Summary: The Obama Administration is continuing the Bush team’s Wall Street friendly policies, probably because they believe, as do most economists, that the downturn will hit bottom in the 2nd half of this year, and slow growth will resume next year. That’s bad. As a result they are missing an opportunity to fix the financial system, clearing their desk for the next wave of problems. That could be a catastrophic error. As always when looking ahead in this crisis, these are just guesses.
Contents
- Stress testing the banks: real or faux?
- Why are they doing this?
- The next phase of the crisis
- Possible Consequences
- Afterword
- For more information
(1) Stress testing the banks: real or faux?
Having regulators do stress testing of banks’ balance sheets is a good idea. Many or most would be shown insolvent under reasonable assumptions involving, for example, a severe downturn lasting into 2010, with peak-trough GDP down 5%. That would be the worst downturn since WWII for America, but common in our history — and more common in modern world history. That finding might break the logjam over fixing the financial sector: rising public anger over the “bailouts” (gifts of public money to banks and brokers) vs. a Washington elite mostly in Wall Street’s pocket.
This might allow rapid nationalization of the affected banks. Perhaps a domino effect, as nationalized banks might have a substantial competitive advantage over private banks — such as a greater perceived solvency and a lower cost of funds. This would clear the desks of Obama’s team, allowing them to focus on their political agenda and — more important — deal with the next wave of problems as the financial crisis moves down Main Street.
But it appears that they are not doing this. Instead we get more kabuki, probably faux stress tests designed to boost confidence.
Note: imagine if other professions were run like the government. Instead of fixing your car, removing your appendix, of defending you in court — mechanics, doctors, and attorneys could lie to you in the hope of boosting your confidence!
See page 4 of the FDIC description of the stress test. The “capital assessment” will cover 2 economic scenarios: an absurdly optimistic baseline scenario and a slightly more “adverse” scenario. Here are the adverse scenario assumptions for 2009 and 2010. These would work as the baseline scenario.
- Read GDP of -3.3% and +0.5%.
- Civilian unemployment rate: 8.9% and 10.3%.
- Home prices: -22% and -7%.
For more on this see “Wait And See” by Simon Johnson (was Chief Economist of the IMF, now MIT professor), The Baseline Analysis, 25 February 2009 — Excerpt:
So the banks have – by assumption – sufficient capital. The stress test will be relative to this baseline; you can see that the “maximum stress” will be pretty mild and, very important, short-lived. President Obama therefore can present and emphasize his (admirable) long-term goals, as he did last night.
I just have one question. How exactly do we get growth over 2 percent in 2010 (and after)? The global economy is getting worse, consumer and business confidence is weak everywhere (tell me if you know different). There is no sign of housing turning around, consumers are cutting back, and large organizations are all planning to trim costs for the next financial year. Our policy response so far: moderate fiscal stimulus, underfunded housing policy, and small potatoes for the banking system. Monetary policy sounded bold a month ago; now less so (again, if your central forecast is so rosy, why embark on risky or controversial further monetary expansion?)
The answer is: wait and see. If we get a recovery, then we are fine. If there is no recovery, we’ll deal with it at that time and we can bolder at that time.
Economist Paul Krugman also finds this plan depressing, as we see in these two posts in his blog at the New York Times:
- “Not much stress“, 25 February 2009
- “Feelings of despair“, 26 February 2009.
(2) Why are they doing this?
My guess is that Team Obama is hoping to “keep their options open”, one of the classic modes of failure for decision-makers facing difficult choices. Unfortunately time relentlessly closes options. Every decision taken closes options. Every opportunity missed closes options.
(3) The next phase of the crisis
Bad things are coming. Governments have deployed a wide range of fiscal and monetary police measures, but these can only mitigate the suffering and damage to economic infrastructure. Also, most are too small. As people and their leaders understand the potential magnitude and duration of this downturn, additional rounds of fiscal stimulus will be approved. (See this presentation by Richard Koo, who describes Japan’s experience)
Public policy measures have seldom if ever sparked a recovery. Economies recover when the imbalances that caused the downturn are burnt off. In this case, that means the excess private sector debt is defaulted, refinanced, inflated away, or socialized. Also helping to spark the recovery will be low asset prices, which eventually stimulate private investment.
Getting there will be painful.
A fair number of our major banks are technically insolvent, even after many rounds of government bailout programs. Public anger is rising as they see vast sums of our money funneled to Wall Street. Slowly the realization spreads that recapitalizing the banks will take several trillion dollars, a sum impossible for even the cleverest apparatchik to gift to banks.
Note: Legend has it that Hank Paulson was once asked if it was in the people’s interest to have so many ex-Goldman Sachs partners working in the Treasury Departments of Western nations. “There is no such thing as an ‘ex’ partner of Goldman Sachs” he replied.
Another note: Paulson did not say that. Putin did say that about the KGB. But the earliest instance I find of this is by Aleksandr Nikitin, the ex-Soviet Navy officer arrested on charges of treason in 1996 for exposing the Russian Navy’s harmful nuclear dumping practices. He said “There is no such thing as an ex-KGB employee, just as there is no such thing as an ex-German shepherd.” (Source: “The Two Worlds of Vladimir Putin”, Amy Knight, The Wilson Quarterly, Spring 2000 — subscription only)
To use another bad analogy, the crisis has been traveling during the past two years through the virtual space of “Wall Street” – the financial markets. That has caused severe damage. During the 4th quarter it made landfall at Main Street. Now it travels through the real economy, leaving behind a trail of unemployed people and wrecked businesses. During the next two years our government will be busy coping with the resulting bankruptcies, poverty, and structural damage. Plus any geopolitical turmoil caused by this global depression.
Our leaders must clear their desks NOW to prepare.
(4) Possible Consequences
The Obama Administration has many bold policy objectives. Reforms in health care and education. To re-unionize US companies. More critically, they must manage the domestic and international dimensions of the depression while winding down the war in Iraq and heating up the one in Afghanistan.
It’s a heavy schedule. Fail to deal expeditiously with problems, they risk getting overwhelmed by events. Their observation-orientation-decision-action loops (OODA loops) can fall behind the situation, so that they cannot effectively absorb new information and forecast events — the basis for planning and executing policy. As the late John Boyd (Colonel, USAF) said in page 44 of The Strategic Game of ? and ?:
{the decision-maker} will experience various combinations of uncertainty, doubt, confusion, self-deception, indecision, fear, panic discouragement, despair, etc.,
which will further disorient or twist his mental images and impressions 0f what’s happening;
thereby
disrupt his mental maneuvers for dealing with such a menace;
thereby
overload his mental capacity to adapt or endure;
thereby
collapse his ability to carry on.
OODA loops are especially vulnerable to this form of collapse when operating without a plan. Plans provide a context for new information and a baseline of policy from which policies can be modified. This is a common cause of battlefield defeat, and I suspect contributed to the failure of the Hoover Administration in 1930-32.
(5) Afterword
Please share your comments by posting below. Per the FM site’s Comment Policy, 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).
For information about this site see the About page, at the top of the right-side menu bar.
(6) For more information from the FM site
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest these days:
- About Financial crisis – what’s happening? how will this end?
- About the Obama, his administration and Ameican policies today
- Good news about America, a collection of articles!
Forecasts about the crisis:
- Geopolitical implications of the current economic downturn, 24 January 2008 – How will this recession end? With re-balancing of the global economy — and a decline of the US dollar so that the US goods and services are again competitive. No more trade deficit, and we can pay our debts.
- What will America look like after this recession?, 18 March 2008 — The recession will change many things, from the distribution of wealth within the US to the ranking of global powers.
- Consequences of a long, deep recession – part I, 18 June 2008
- Consequences of a serious US recession – part II, 19 June 2008
- Consequences of a long, deep recession – part III, 20 June 2008
- A look at one page of what lies ahead in America’s history, 7 August 2008 — Death of an American industry.
- Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
- Forecasting the results of this financial crisis – part II, a new economy for America, 14 October 2008
- A look at the next phase of the crisis, as it hits the real economy, 31 October 2008
- A look at out future, 2009 – 2010 … and beyond, 9 November 2008
- A look at 2009 economy – some guesses, 28 December 2008
FM, regarding # 25, the tone of your response absolutely proved my point. I didn’t realize being an economic prophet was so important to you. Wow. The US had too much debt? There were trade imbalances? Poor regulation? Questionable monetary policies? Best yet, there was really a bubble in the housing market when everyone who owned a home was putting theirs on the market due to the extraordinary prices being paid? Generally predicting economic castastrophe doesn’t redound to your credit without specifics. For example before the 1929 crash the NY Times spent months predicting all manner of doom. When it happened, albeit in a way the Times did not predict, the gloating was not exactly subtle. But as Galbraith noted while we naturally focus in critical reappraisal on those who say that the economy is sound before a sharp downturn, those who make a similar vocation of predicting economic doom are often just as unsound in their own judgment as the seeming Polyannas we take such pleasure in revisiting.
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Fabius Maximus replies: I do not understand what you are attempting to say. If the forecasts here were insufficiently precise for you, you are welcome to go to sites where the content meets your high standards. If you have a criticism, please base it on a quote or specific reference.
I’ll streamline it for you. Your previous posts have references to the subprime mortgage problem and the housing bubble and debt among quite a few other things. Now please point out the post where you stated that because our financial institutions through exotic financial instruments were insanely overinvested in insecure mortgages to the extent that a catastrophic failure of our banking and credit system could result. That would not be beyond any human agency, particularly as you were identifying the pieces of the puzzle. If you did that then congratulations.
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Fabius Maximus replies: What is the point of this carping? As I said before, you are welcome to transfer your attention to sites meeting your high standards. IMO you are not saying anything of use or interest.
Interesting points. I concur with you on the future outlook. The source of the crisis is multi-dimensional and both parties bare the blame for it, however, the Democrats appear to be using the crisis to pursue an aggressive change in the basic tenets of the economy. With Bush starting the process, Obama, Reid, and Pelosi are converting our market economy into a command economy. I think our Democracy is strong enough now to recover but I am afraid the people lack the mental and political strength of will to take back control. Right now the only strong charismatic leader in this nation appears to be Obama and clearly he is charging in the wrong direction.
People blithely use the word nationalization of banks. What is the OODA loop of bank nationalization? Do those commentators above know, does FM know? My feeling (not knowledge) is that the genius technocrats in Washington peeked under the cover of the box marked universal or money center bank nationalization (remember these are not local or regional banks) and recoiled in horror.
My limited understanding of nationalization:
1) If you nationalize one, say Citibank, the next in line will be shorted or attacked, say BofA, which if nationalized will lead on to JP Morgan, then Wells Fargo, and on and on…
2) Each of these banks represent huge amounts of capital intricately connected to other entities by complex instruments, such as CDOs, various kinds of preferred stocks, common stocks, bonds, swaps, loans, insurance and other obligations. So very quickly insurance companies, other banks, reinsurance companies, hedge funds and other companies will start to weaken even more as the capital on their books represented by these various obligations evaporates. Will we nationalize them too?
3)Much of the bank capital is also to be found in pension funds, endowments, foundations, IRA’s, 401K’s, and mutual funds. Will we step in and make them whole also?
4)I don’t know the aggregate number but have seen figures in the $100s of trillions when you total up the whole ball of wax.
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Fabius Maximus replies: Banks have often been nationalized. By Sweden in the 1990s, the US experience with the S&L’s. It is hardly the horror show you describe.
(1) Unless crafted well, a nationalized bank might have a competitive advantage vs. competitors (e.g., lower cost of credit, greater percieved solvency). That might tip other money-center banks into nationalization.
(2) Nationalization makes the complex chain of finanancial relationship more stable — not less, as you imply. A major stress on the system is counter-party risk, which goes away when dealing with government-owned entities.
(3) The remaining equity market value of the major banks is tiny, so nationalization will have little effect. By stabilizing the sector, the value of bank bonds might rise — even if the government gives a “haircut” to the bonds as part of “sharing the pain” of nationalization. Given the massive amount of bank debt in the system, this might have a very beneficial effect.
(4) Let’s not get hysterical. As I have explained several times. numbers like that are losses from an atomic war — not any plausible financial event.
/But events might force him to become a real leader, effecting major changes. A similar story to Lincoln’s.//
Fabius. This is the first I’ve seen of your blog. I’m hooked. Our outlooks are very similar (which means we could both be deluded).
On to your comment: Obama seems to lead by “default” – reacting to events, rather than anticipating and leading them. This was my read of his entire election campaign. He’s easy to sucker punch but brilliant in response. I just wonder if my read of Obama is correct and, if so, whether he has the grit to get ahead of national and international events.
I will stick to my position that economies could just shrink . I grew up in the ’50’s but I’m not just using rosy glow of childhood or imagining manna from heaven .
Things had got too darn complex . As a stupid little example , If Gov could send out a piece of information in 1955 on a piece of recycled card 4 inch by 6 inch , why do they in 2008 send me a 10 page , photo-filled A4 brochure , to convey a similar amount of imformation ?
I’m now , in my limited field of work , seeing my customers and staff make rational decisions about spending , rather than unrealistic ones . Its nice to see them using their minds , thinking ahead , looking at options , even scribbling on backs of envelopes . My business has to adapt to the new , low spend customer .
I’d hoped my Gov ( UK ) would adapt to the new , lower profit businesses that it relies on , in the end , to feed it : not be surprised when the Jan tax take from biz was way down ; slash spending ; negotiate payment plans with their creditors . That way they would be representing the (insert german word for behavior + intent ) of the people .
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Fabius Maximus replies: Nobody doubts that economies could just shrink. You just seem oblivious to the results. Please post your address so that we can send the unemployed to you for food, shelter, medical care, etc. Also, shrinking economies mean certain bankruptcy for our social retirements systems, causing severe dislocation for decades to come. In the event of severe social instability, we’ll call you for solutions. Also, please prepare recommendations for any resulting wars.
Nice post Fabius. My view’s of Obama are a bit less pragmatic and hopeful as I watch the destruction of what was America but what can I do. The jump to socialist policies which haven’t worked anywhere else combined with comments like #70 who thinks obama’s brilliant leave me dumbfounded. It’s beyond me how people think..
The OODA loop also applies to a person (or government) with a perfecly clear view of the situation but not enough flexibility to react to a situation. The bane of all socialism. Wait until the government is bulk ordering the amoxycillin for the whole country and they don’t have enough, who’s going to react. I guess I’m a permanent skeptic but since my own business is struggling under this economy, I can still hope I’m wrong.
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FM replies: Jeff Id writes at his site, The Air Vent, and is an active analyst of global warming research. His work deconstructing Steig 2009 (“Warming of the Antarctic ice-sheet surface since the 1957 International Geophysical Year” in Nature) has made a valuable contribution to understand this important and high-publicized but poorly documented paper.
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FM:”(1) Unless crafted well, a nationalized bank might have a competitive advantage vs. competitors (e.g., lower cost of credit, greater percieved solvency). That might tip other money-center banks into nationalization.”
For a borrower I don’t believe the solvency of a lender makes all that much difference. Depositors are already covered by FDIC and they do trust this system. But, for example, what should be the interest rate be on my “US Government Bank” credit card be? How does that work? Can Obama give the order and change credit card interest rates if the government owns the banks? Should the “US Government Bank” offer free checking? Will the “US Government Bank” have the political will to pull the plug on a business that’s critical to some congressman’s community? Also Citigroup has customers overseas, in Muslim countries, for example, where the recipients would be legally entitled to get a loan, but that might make political trouble here in the states. Should we loan to overseas companies that don’t have equal pay for women? There’s all kinds of opportunities for the US political system to short circuit this.
There’s an economist, I forget the name, who favored nationalization, but only for an hour. At least we’d have to maintain some kind of wall between government decisions and banking decisions.
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Fabius Maximus replies: Yes, your Christmas Card account, car loan, and CDs are not affected by these larger events. But companies who borrow their working capital from banks need to know the bank can provide funds when needed during difficult times. As do the people who loan the money to banks. And the merchants, shippers, and manufacturers who rely on the letters of credit which make the global machinery run. Banks are key intermidiaries in our system, counterparties to a long list of businesses and investors.
The rest of this is just silly. The government operates not just banks but businesses of every kind in free market systems all over the world — including utilities, health care systems, and liquor stores. They work just fine, certainly better than our private sector banking system. The point of nationalizing the banks is to recapitalized them and sell them off when the economy recovers.
I am not hysterical. This whole mess seems to be a chain of unintended consequences. Before we forge another link to that chain we should be very careful.
1) The banks in question are not Swedish banks or the S&Ls of the 1980s. They are very much different.
2)Mark to market accounting was not in use in either earlier case
3)The variety of sophisticated instruments involved in this crisis didn’t exist in those crisis’s
4)The scale of the problem is much different
5)The banks involved in this crisis were regarded as safe and desirable investments hence the equity which would be wiped out is equity spread throughout our society. I know a plumber retired on a Plumbers Union Pension who has already been warned that they may not be able to continued his pension.
6)Do you know the names of the banks in question? How many are there? What is the total equity which will be wiped out. What will be the effect on a huge slew of other companies which hold equity and financial instruments of these banks? What about a bank like HSBC (the world largest company and largest bank holding group) not American but with a branches in many US city and towns?
7)Most of this crisis has been caused by people doing something with the best intentions: mark to market accounting, easy money, creation of the sub prime industry to raise home ownership levels, creation of complex financial instruments to reduce or pass on risk and raise profits, and passing various laws which, again, had unintended consequences. Now we find ourselves on the road to hell.
8)A card laid is a card played. If we keep violating the underlying sanctity of contracts when ever we think it’s for the best we will find that no one will risk one dollar in markets where rules can be changed and abrogated on interest group or government whims.
8)Let’s look very carefully before we leap or perform an Immelmann.
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Fabius Maximus replies: You are hysterical, in the sense of tossing around absurdly large numbers.
“I don’t know the aggregate number but have seen figures in the $100s of trillions when you total up the whole ball of wax.”
Hundreds of trillions represents the losses from an atomic war, not any concievable finanical event — looking at the US or even the world.
For comparison, total assets of America’s homes and businesses (excluding farms and financial firms) is aprox $100 trillion. A financial event would not destroy this, our physical infrastructure.
The financial system is far smaller, of course. Total US loans are aprox $26T, of which bank loans are $1.6T and mortgages $11.4T (much of this is outside the banking system). (the numbers are from the Fed’s Flow of Funds report, Q3 of 2008)
The EU numbers are roughly the same magnitude. As of Dec 2008, the current European Central Bank report shows that “member monetary financial institutions” (which they define quite broadly) had consolidated assets of 24.1238 Trillion euros. That includes everything, down to the Chairmen’s secretaries’ nail polish. Their “risk” assets (excluding government bonds and fixed assets) are 18.2 EUR (excluding derivatives, another problem).
What might be the losses in another Great Depression? For comparison, bond defaults were 10% in the worst year of the Great Depression. Big, but nothing like Armageddon. Note those weren’t losses, since they recovered something from the collateral on those loans (recovery rates on junk bonds have averaged 40% during the last few decades).
The Citigroup balance sheet was around a couple tril’ and BAC was around a tril’ and a half, and these are the biggest. I figure the top 6 banks would have to be somewhere between $5-$10T total for their entire balance sheets. That would be, guessing $7T of real debt and $7T of assets of dubious and collapsing value. {snip; don’t guess, use the Fed data that I have linked to so many times in your comments}
If we nationalize the top banks, that sucks these balance sheets onto the US balance sheet. The US national deficit is maybe $10T or so, and this would add, err, guessing about another $7T to it, and the bank assets become government assets.
The blog-o-sphere is all abuzz of this story here: “Time to expose those CDOs“, Financial Times, 26 February 2009 — Excerpt:
This’s pretty spectacular. So much for AAA assets these days. What the nationalization argument is oversimplifying, nobody knows the depth of the problem here. We don’t know what kind of contracts and agreements are out there, and what happens to all this stuff it it’s the US government now.
For example with the Lehman collapse what really nuked the world was the AIG connection, and this was totally unexpected. Maybe this is why Bernake has essentially killed the nationalization option for now, because they’re just scared. I wouldn’t blame them.
Here’s some fallout, just from the bailouts so far: “Buffett’s bailout headache“, Fortune, 28 February 2009 — “The billionaire investor supports federal rescue efforts – even though they’re squeezing his Clayton Homes housing finance business.”
Ooops, sorry guys. You give some players in the game the power of the government behind them, what happens to everyone else? You’d think this is the kind of company we’d like to keep around.
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FM replies: Blah, blah, blah. Why not comment about the sun coming up tomorrow. Every half-conscious person in this nation should know by know that either many of the major banks are toast — or we become so if this downturn is long and deep. Get a grip on yourself; get over saying “oh my god” about each new headline. The milk is spilled, the question is about how to clean it up. Soon we will have serious problems to worry about, and the banks will be like #47 on the list.
Your comment about the national balance sheet is absurd. Taking assets and liabilities onto the government balance sheet is an accounting entry. Buying assets for a billion $ is not the same as spending a billino $ on goods or services. In financial transactions what matters are the losses, which (as I have said too many times) will be a fraction of the liabilities. Serious money, but a dot compared to the expenditures which might be necessary to keep the US going through the next few years.
The phrase is actually “there’s no such thing as former Chekists” (byvshikh chekistov net). It predates the KGB, probably Dzerzhinsky said it first. It’s a pretty common phrase in Russian and is used in many cases besides its literal meaning. Russians would certainly use it in the sense Paulson did.
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FM reply: Thanks for this additional information.
From Wikipedia: The Cheka (Extraordinary Commission) was the first of a succession of Soviet state security organizations. It was created by a decree issued on 20 December 1917, by Vladimir Lenin and subsequently led by an aristocrat turned communist Felix Dzerzhinsky. … From its founding, the Cheka was an important military and security arm of the Bolshevik communist government. In 1921 the Troops for the Internal Defense of the Republic (a branch of the Cheka) numbered 200,000. These troops policed labor camps, ran the Gulag system, conducted requisitions of food, liquidated political opponents (on both the right and the left), put down peasant rebellions, riots by workers, and mutinies in the Red Army, which was plagued by desertions.