Monday, September 22, 2008

Getting warmer

James Surowiecki has a nice piece in the New Yorker where he almost, but not quite, gets that, in a fractional reserve banking system, liquidity = solvency for financial firms:
That’s because the entire edifice of Wall Street is built on confidence. Investment banks rely on short-term debt to run their businesses, and their businesses consist of activities—trading, dealmaking, money management—that depend on people’s faith in their ability to honor their obligations. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse, they become less willing to lend or to trade, and more likely to demand their money back. The perception of weakness exacerbates the reality of weakness. And although there are myriad measures of a company’s health, nothing looks scarier than a stock price that’s heading toward zero.
I don't like the word "confidence" when describing the technical willingness to rollover short term debt, because it makes it sounds as if the problem can be solved by some trust building exercises, perhaps some group singing, instead of highlighting that the system is fundamentally, unpredictably unstable, and that there are two prices for long term maturity mismatched securities, not one. This isn't a problem of confidence in the same way that a pencil refusing to balance on a point isn't a problem of "gravity". In retail banking, the problem was solved by essentially having the government lend to banks while they kept depositor's money in the vault, but there is no formal solution to this in the investment banking world.

Dean Baker usefully assembles a load of anodyne pablum and labels it the Progressive conditions for a bail out. Having been clearly labeled, it is now easy to avoid. The Reactionary solution is in the comments, here, and it's quite possible moldbug would include some public beheadings to deal with the Moral Hazard problem.

The Dodd plan comes closer to my preferred solution -- complete nationalization of the financial sector -- by having warrants that convert to an equity stake if taxpayers lose money (which they must, since this is a transfer of capital) AND recognizing that both the debt and equity for financial firms is worthless, so a straight Zingales style swap will not help matters. The Treasury does not want taxpayers to be protected, and is rejecting the Dodd proposal. I hope we are all clear now on who really runs things in DC.

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