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The Problem, the Solution
By Charles Zentay March 21, 2008
First, we must
understand the problem, which is fractional banking. The
problem with fractional banking is that cash ALWAYS has to be less
valuable than other alternatives. Otherwise, there is an
immediate desire to deleverage (to get into cash), and the whole
interconnected banking system, with all its counterparty risk, comes
crashing down. We are seeing this problem now. Because raising
interest rates makes cash more valuable, the system is inherently
biased towards needing and encouraging lower and lower rates.
Look at the trend in interest rates ever since Volcker left office:
it’s down, down, down, a touch up, down, down, a touch up, down,
down, down. The deleveraging
problem could have happened in 1995 (the year Greenspan uttered the
words “irrational exuberance”), 1998 (Long-Term Capital, the
Russian debt crisis), 2000 (the dot-com bust), or many other times
in recent history. That is why the Fed has been running scared
for so long. For two decades, the Fed and government have
fought deleveraging by encouraging more leverage (mostly by lower
interest rates, but also by deregulation, the allowance of
off-balance sheet vehicles and the overnight sweeping of checking
account, etc.). However, the
leverage can’t go on forever. At a certain point, the
leverage becomes ludicrous. The excess credit drives asset
prices up to a point where the earnings on these assets do not
justify the risk of acquiring them (3% rental yield for an apartment
whose value is supported by a clearly overleveraged banking
sector???). You know something is wrong when the most
respected banks are 32 times leveraged (does that even count all the
off-balance sheet agreements, the derivates, and the effects from
any mark-downs on the asset side???). So basically, as I
pointed out in August, the U.S. is the subprime lender of the world
(along with Europe!). Our entire banking system was then and
is now obviously bankrupt.
1) Preserve the value of the currency and let the banking system crumble. Honor contracts and force bankruptcies. Purge the system of its excesses through a massive depression. DOWNSIDE: Massive unemployment and a serious contraction in the economy. UPSIDE: Faith in the currency is maintained, the banking system is cleansed, and many decades of healthy, long-term economic growth can be built upon a solid foundation. [NOTE: Your average economist erroneously believes that the Fed’s inaction during the Depression was the problem. The real problem, as it always is, was the Fed’s previous allowance in the 1920s of excessive credit growth. Because of this lack of understanding, your average economist is not inclined to ascribe any long-term benefit to the Fed’s purging the system of its excesses.] 2) Change the rules of the game. Have an activist government try to prevent bankruptcies. There are many ways to change the rules of the game: The Fed can start to monetize and retire assets, such as mortgages, corporate debt, etc. Alternatively, the U.S. government can have the Fed monetize its debt, and use the new money for public works programs or simply send the money directly to citizens. Such a process of rules changing will be highly contentious because it will favor certain segments of society over others. It will be extremely political. [For example, if Congress sends checks directly to people, the banking system will cry: inflation. If the Fed recapitalizes banks with cash, the people will cry: bailout]. DOWNSIDE: A loss of faith in the currency, especially among foreigners, who hold the currency (and its implied liabilities) but do not get the benefits associated with monetization (the money is only given to U.S. citizens or U.S. entities). Given that 70% of the entire world’s central bank reserves are in dollars, such a loss of faith could have dramatic consequences. All the benefits the U.S. received from decades of printing U.S. dollars and sending them abroad for goods could quickly reverse, and we could see trillions of U.S. dollars come home, quickly diluting their value and causing hyperinflation and a run by everyone (including U.S. citizens) into anything but U.S. dollars. UPSIDE: Although uncertain, this option is thought to be more likely to preserve economic growth and employment. It is considered to be less painful.
Given that our
national psyche was so scarred by the Great Depression (Option 1), I
fully expect our politicians to go for Option 2. It will be
interesting to see if Option 2 works out any better. It
certainly did not for Europe before World War II, which is why their
central bank is taking such a divergent approach. Unfortunately,
there is no free lunch. Excessive credit and leveraged were
not only allowed to occur, but were the explicit policy of our
government. Now we must choose a way to deleverage: either by
a recession or by inflation. The trick is to deleverage in
such a way that neither foreigners nor citizens lose faith in the
system. Can that be done? We shall soon find out!
It’s going to be a wild ride. Given that we are
on the inevitable path to changing the rules of the game (Optioin
2), my proposed solution is that it should be done in a clear,
unified, upfront and immediate manner. We need to get people
to understand the problem and solution quickly. If it is done
in piecemeal fashion, markets will gyrate wildly as they have been
doing (“We’re headed for a major recession, sell everything”
one day, followed by “The Fed will sink the dollar to prevent
recession, go to commodities and stocks” the next day). Such
wild gyrations are likely to cause a loss of faith in the system
(“It is rigged,” “It’s impossible to make money without
knowing the next move out of Washington.”) Every time a
minor solution is proposed, the market rallies sharply. But
the market soon realizes the solution is not working and goes back
downward, forcing politicians to come up with yet another solution.
Given the enormity of the problem, the solution should be
comprehensive from the start. The real question
to answer is: to whom
does the new money the government will create go first? The
banking sector or the people? A select group of people or all
people? My take is that the only way to put together as
comprehensive a deal as is needed is to be totally fair. Send
each and every American, regardless of age, indebtedness, health, or
any other measure, a check for $30,000. It’s a one-time
thing. Get the Fed to monetize the Federal government debt
that will be created to issue the checks. The Federal debt
should have an infinite term and 0% interest (meaning it will always
be on the government books, but never needs to be repaid).
Will such a plan hurt the dollar? Probably. But maybe
not. Will it be inflationary? Yes, but a lot of the
money will be used to pay off debt, which will help deleverage the
banking system and decrease money supply. Basically, what you
are talking about is a plan to repartition the assets of a bankrupt
banking sector in as painless a way as possible. But you are
doing it in a creative, comprehensive, and quick manner, without
having to run everything through the bankruptcy process. I doubt such a plan
would get very far, especially as all the people of Wall Street and
all the establishment economists would fight it (mainly because it
would be an equitable distribution of the value held by the banks,
and it would --- in relative terms --- disempower the rich and make
those less fortunate less beholden). However, it might be the
only option for the banking class, and the best way to avoid a total
collapse of the system. Through this solution, the banking
sector may emerge better off than other alternatives.
© 2004-2008 Biiwii.com
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