The EU: Towards and ever closer Union

Over the weekend, a friend of mine argued that the founders of the Eurozone knew that a monetary union without a fiscal union would come undone. So they sowed the seeds of a fiscal crises into the EZ, gambling that the unavoidable pain would be enough to force fiscal union but not so much that the monetary union itself would crumble. At the heart of all of this would be to bind Germany and France together irrevocably.

The ECB continues to try and thread this needs with its latest bail out -- more money, more time, but more pain. If the pain ceased, the push for fiscal union would also cease.

Kicking the can down the road is normally considered idle procrastination. This is different. This is deliberate procrastination. If Greece falls today, nobody knows what kind of economic domino effect it will have on other debtors like Portugal, Italy, and Spain, or the rest of the Europe. Europe has selected the muddle-through and draw-random-recovery-lines option. The honest and inevitable choice -- a wild default or even Greece's departure from the EU -- is impossible for euro ministers to imagine suffering through, for today. Meanwhile, Greece suffers.

Not deliberate procrastination. An engineered application of political pressure. We'll see if it's been calibrated correctly.

Recapitalize the non-Govt Sector, not the Financial Sector

When you have a credit bubble -- ie. banks make loans that do not get paid back -- then the subsequent credit bust de-capitalizes banks (as they must write down assets and equity) constraining their ability to lend anew.

As the non-government sector needs additional financial assets to grow, if banks cannot lend (capital constrained) then the economy as a whole starts to trouble.

This, in a nutshell, is where the "Too Big to Fail", "We Must Bail Out the Banks" argument comes from, and it is true, as far as it goes.

Nevertheless, there is more to the story. First, if banks were making loans that did not get paid back, then they were not doing their primary job which is to make good credit decisions. Bad credit decisions should be punished, and the owners and operators of such companies should be fired and/or wiped out. This is how markets work. Rewarding such behavior only encourages more bad practices in the future, and people (rightly) start to wonder why we have a financial system at all.

Second, if banks fail, that contraction in private financial asset growth can be balanced by "capitalizing" the rest of the non-Governmental sector directly (through some combination of tax cuts and spending increases -- whatever increases the deficit). Since economists at Harvard and Princeton do not understand that the Government is the sole creator of net financial assets (equity) for the private sector, they do not know that this policy lever is on the table. So we are where we are.

From Macroeconomic Resilience

My policy proposal has three legs all of which need to be implemented simultaneously:

* Allow Failure: Allow insolvent banks and financialised corporations to fail.
* The Helicopter Drop: Institute a system of direct transfers to individuals (a helicopter drop) to mitigate the deflationary fallout from bank failure.
* Entry of New Banks: Allow fast-track approvals of new banks to restore banking capacity in the economy.

The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. The helicopter drop of direct transfers helps prevent a deflationary collapse and the entry of new banks helps maintain lending capacity thus negating both concerns.

Financial "reform" bill a dud

Yves is merciless about the Obama administration's financial "reform" bill:

I want the word “reform” back. Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are.

So what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.

The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks. And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on. In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.

Most of the rest is mere window dressing.

I have a lower opinion of the bill than Yves, since I don't like the consumer protection agency. I see that as to households what the bond rating agencies are to corporations -- third parties with no skin in the game whose job it is to keep you "safe" by making credit decisions for you. Not only did the ratings agencies fail, they actually made things worse by enabling bad credit to pass as triple-A. A loan is not a product, it is a combination of a financial instrument and a borrower, and treating it as if it were a product, "good" or "bad" by itself, misses the fundamental nature of a credit transaction, which is a promise between a lender and borrower.

I also don't like the "audit the Fed" provision. What are they going to do? Send Bernanke to jail? Which leaves nothing in the "good" column.

Bernanke cannot do Accounting

Bernanke demonstrates the squalid state of Economic Theory:

debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. Bernanke (1995, p. 17)

Voila -- Bernanke does not understand the difference between assets (which really is just a transfer, ie the Internet bubble) and debt.

Banks do not loan out deposits. Savings do not get given, by banks, to borrowers. Investing in a mutual fund, there the fund manager doles out your cash to a company, is nothing like putting your money in a bank, where the bank manager certainly does not dole our your money to a borrower.

Banks create loans by expanding their balance sheets. The money is created as an asset and a liability, simultaneously. Therefore, debt deflation is not a simple transfer, where balance sheets stay the same size, but a contraction, where balance sheets shrink as assets and liabilities are both written down.

We are two years into this crises, and the basic mechanism for bank lending remains opaque to the Chairman of the Federal Reserve.