The Bailout Won't Prevent Deflation - A Look at Our Prior Great Depressions

The Bagehot remedy is to inject liquidity at a banking panic, and withdraw it during the boom times; but while we usually do the former, we constantly neglect the latter.  Hence the boom/bust cycle continues. This bailout is not so different that it hasn't been tried before, but it is coming at such a rush and in such a charged political atmosphere that its flaws may escape fixing until well into the next phase of the crisis.  In particular, this political dynamic may embolden the 'foxes' who got us into this mess to continue with reckless government lending while gaining political support for much increased intervention in the financial sector. 

Partly as a consequence, the bailout will not prevent deflation.  Let's look at the history of bailouts and financial panics, and why deflation is now inevitable.

A Short Walk Through Panics and Bailouts

We have had three Great Depressions: 1837, 1873, and 1929.  Each followed a credit bubble.  The 1873 one stretched until 1896, but was not as deep as the other two.  Interesting that the shortest one had no government intervention, and the mildest had minimal intervention.  The worst was the one we tried the most to do something about.

We did the Bagehot remedy at various degrees of speed and size a number of times, including in 1825 (UK), 1873 (US) and 1929, as well as 1897, 1907, 1987, 1997, 1998, 2000, 2001, 2003-4 and 2007-8. 

We have only once gone through the crisis without applying the remedy: the Panic of 1837, after Andy Jackson shut down the Second Bank of the US (which was actually our 3rd central bank).  The Republic survived, and the Depression was relatively short-lived (5 years) compared to the 1873 and 1929 panics.  Nevertheless, the shock of the 1907 panic led to reinstating the central bank, the Federal Reserve. 

But we have also gone further than the Bagehot Remedy before, such as in the early 1930s where we had both a homeowner mortgage program and a resolution trust type of program to buy bad debts off banks.  This bailout in amount (inflation adjusted) goes about 2x beyond what we did in the Depression, especially when we remember that just a few months ago Congress passed a $300B housing bill. As a percent of GDP, however, this bailout is a baby compared to the Depression bailouts, which crested at 60% of GDP.

We also did this in 1989 to bail out S&L's after we had imprudently privatized the upside (let S&L's engage in risky lending) while maintaining the socialization of the downside (guaranteeing deposits).  We lost money on that one, but it was less expensive than first anticipated.   

The crux of today's problem is similar, just much larger in scale: we socialized the downside to a much larger degree by subsidizing an ever increasing family of mortgages and student loans (Fannie Freddie And Sallie Mae, among other GSEs), and privatized the upside.   

The current problem may also end very badly.  Much is being made of the HUD - Community Organizer - Democrat Complex which has driven these GSEs to levels of recklessness beyond belief.  By one count the Republicans tried 12 times to stop it, and were blocked each time.  To this day these agencies are still offering subsidized mortgages to people who cannot even make their first payment.  The feckless are lending to the reckless.  Utterly irresponsible.   The whole subsidized mortgage game will end hurting the innocent (taxpayers) and the prudent (people who did not buy beyond their means, and watched houses get too expensive due to all the reckless buyers). 

UPDATE 10/29: Obama has claimed not to be part of the cabal that drove Fannie to excess, and in a debate even claimed to have sent a letter to try to stop it.  The WSJ reviewed the letter and reported today that he never proposed pulling back on the risky loans; quite the contrary:

we note that nowhere in his letter did Mr. Obama suggest that the government should stop subsidizing loans to people who can't repay them. 

The deep irony of our current politics is the very foxes who created this nightmare (the Demo leadership in Congress) are about to own the henhouse. 

A Digression Into Deregulation

The foxes point the finger at deregulation, and specifically the 1999 repeal of Glass Steagel.  This is a huge misdirection, a red herring.  Robert Rubin has said that Act had "nothing" to do with the current crisis.  Since it was on his watch as Treasury Sec'y that we did this, I take his comment with a grain of salt; but to his credit the money center banks appear to be surviving this crisis much better than the investment banks. 

Instead we should point the finger of blame at a profound failure of the regulators to regulate.  Greenspan deserves what is about to happen to his reputation,  He specifically shirked oversight over the shadow banking system despite a 1995 Act which gave it to him, kept interest rates too low for too long, and refused to apply the Bagehot medicine of withdrawing liquidity when he needed to.  In addition, the current head of the SEC, whom McCain has said should be fired, accepted some responsibility for not applying appropriate oversight of investment banks.  The SEC was given broader authority in 2004, but failed to manage it properly; and perversely the new rules may have enabled the investment banks to leverage up too much.  Cox may have been a goat, but he deserves some approbation for accepting responsibility.  Whom else has, in this monumental mess? 

And much too little is being made of a lesser known dereg to benefit Enron that took derivatives outside of regulatory oversight.  Now we have $500T of nominal value of derivatives, well beyond the $62T of credit default swaps (essentially, insurance against default) that were thrust into the public eye when they caught AIG and left it bailed out in a forced loss of 80% of equity.  This $500T is so far beyond comprehensive that it is essentially being ignored.  Theoretically it consists of shorts and longs that like matter and antimatter will simply cancel out; but if they are off by as little as 10% than we have $50T on one side of the ledger.   That is probably about the total net worth of the whole global economy ... who will bail that out?

The Problems With The Bailout

This bailout at its essence is using taxpayer Dollars to buy toxic debt that no one else wants to touch and leave the banks whole to go about their business.  Perhaps as Andy Kessler in the WSJ speculated we could somehow turn those debts into profit, but who knows? 

There are other ways to solve this problem.  I have elsewhere posted on the 1873 panic, studies of bailouts and the deflationary impact of credit bubbles.  Examples:

• When the bailout seemed stalled in Congress, the Fed injected another huge tranche of liquidity in coordination with other central banks. 
• At extremes, the Fed could issue gold-back securities, monetizing its gold stores. 
• Or more simply, the Treasury could "repo" the toxic debt: loaning against the bad debt, not buying it; and not taking the risk on its ultimate value. 

This is not a crisis of cash flow, like most banking crises; this is a crisis of accounting.  We recently introduced mark-to-market accounting, and much of the problems in the banks have been revealed as they write down assets.  Without getting into a debate over accounting, the mark-to-market problem can be solved by bolstering bank balance sheets.

The Inevitability of Deflation

Under a fiat money system, deflation is hard to fight once it starts.  Keynes pointed out its pernicious impact in the '30s: prices dropped as the Dollar appreciated, yet wages stayed constant and even rose as FDR promoted wage growth and unionization.  The result: a squeeze on companies to make a profit for goods they could sell at volume.  Bankruptcy amidst plenty. 

Today this squeeze is less likely, as outsourcing and flexible workforces make it easier for US companies to adjust to pressure on gross margins.  Yet the fear persists.  The low interest rates of Greenspan after 9/11 and the rush to inject liquidity were both motivated by the fear of deflation. 

Deflation appears inevitable.  We are rapidly deleveraging.  Bear Stearns and other investment banks were over 30:1 leveraged, and with credit default swaps and other derivatives the actual leverage is much higher.  The Universal Banks in contrast will be around 10x leveraged.  Either way we save the banks - bailout or repo - the leverage will be much lower, and hence credit (money) will be lower.  Velocity is also much much lower right now, and is unlikely to grow back to the hectic pace of 2005-2007.  All this means a vast destruction of credit, and a large drop in money, both quantity and velocity.  That is the formula for deflation.  And the frozen credit markets mean that injecting liquidity will not help. 

We are in the liquidity trap, where the Fed can give but the banks won't take.

History will likely show that after they let Lehman Brothers go down, Bernanke panicked.  He is a scholar of the Depression, and is now applying his theory to practice.  He appears to have gone beyond theory into ad hocracy very quickly, and may have feared running out of arrows in his quiver.  A run on the Federal Reserve would have devastated the US Dollar for a generation.  He was already down to under $500B in quality reserves, and one more bank bailout would have put him too low.   He tried to stop the moral hazard by letting Lehman go, but almost immediately realized he had made a mistake, a mistake he could not unwind.  Lehman debt was entwined in many money market funds, and a run on those funds began in earnest. Hedges against a run on the Dollar shot up:  Gold by $100, Oil by $30.  Hence he turned to the deepest pocket of all, the US Treasury, and Paulson rushed out a poorly conceived term sheet that held bankers largely whole while putting the risk on the taxpayer. 

A run on the Dollar would be hyperinflationary, not deflationary.  Bernanke had hit the tipping point, the moment of chaos, and it could have gone either way.  He did the prudent thing to panic!  He may still believe that with a bailout rather than a repo we can all muddle through without deflation. It is an experiment that we will likely get to see play out.

I have blogged previously how the Greenspan Put was in itself a grand experiment in pre-emptive central banking.  We just lived through the failure of that experiment - the very effort of Greenspan to pre-empt a credit crunch and the deflationary depression that follows has instead caused an epic credit bubble and an even worse risk of a deflationary depression. 

At some point, we will decide Enough!, stare into the abyss, and like Andrew Jackson let it come. 

Comments

[pma verzekering]

I don't completely agree with the fact that bailout Won't Prevent Deflation.I think there would be differential expectations of bailout rescue.I also thing if the bailout option is appropriately handled in a well structured economic model we well be actually reduced the recession period.

[Cindy]

Will the stupidity and lies about glbaol warming never end? As for man-made glbaol warming: Don't be concerned. That is political nonsense by politicians and the media. The sun has a variable output; probably the cause of ice ages and certainly the cause of mini ice ages and warm periods such as the Medieval Warm Period from 1000 to 1200 that was warmer than the current warm period. There is no scientific theory that supports Global Warming as presently defined in the media. In fact I know of no reputable scientists that are not paid or bribed with research grants that support man causing glbaol warming. These are the undisputed facts: People point to Venus. However, Venus receives twice the solar radiation as the earth and the atmosphere of Venus is 90 times heaver than the Earth's atmosphere. This is like what a submarine experiences at 3000 ft below the surface of the Earth's ocean. And the atmosphere of Venus is 97 percent CO2 while the Earth's atmosphere is 0.03 percent CO2. Otherwise Venus has 90 0.97/0.0003 or about 300,000 times as much CO2 in their Atmosphere as the Earth. In my opinion, if man could double or triple the CO2 in our atmosphere it was have almost no effect on glbaol warming. Quote 1: The AP said: "Carbon dioxide, the gas largely blamed for glbaol warming, has reached record-high levels in the atmosphere after growing at an accelerated pace in the past year " Facts: Carbon dioxide is not the major greenhouse gas (water vapor is). Carbon dioxide accounts for less than ten percent of the greenhouse effect. Only about 0.03 percent (1 part in 3,000) of the Earth's atmosphere consists of carbon dioxide (nitrogen, oxygen, and argon constitute about 78 percent, 20 percent, and 0.93 percent of the atmosphere, respectively). Water vapor varies from near zero to about 4 percent with an average of about 0.5 percent and ten to twenty times the percent of CO2. The sun, not a gas, is primarily to "blame" for glbaol warming and plays a very key role in glbaol temperature variations as well. For example, the planet Mars is undergoing significant glbaol warming, lending support to many climatologists' claims that the Earth's modest warming during the past century is due primarily to a recent upsurge in solar energy. According to a September 20 NASA news release, "for three Mars summers in a row, deposits of frozen carbon dioxide near Mars' south pole have shrunk from the previous year's size" Because a Martian year is approximately twice as long as an Earth year, the shrinking of the Martian polar ice cap has been ongoing for at least six Earth years. Quote 2: The AP said: "Carbon dioxide, mostly from burning of coal, gasoline and other fossil fuels, traps heat that otherwise would radiate into space." Fact: Most of the carbon dioxide in the atmosphere does not come from the burning of fossil fuels. Only about 14 percent of it does.Quote 3: The AP said: "Global temperatures increased by about 1 degree Fahrenheit (0.6 degrees Celsius) during the 20th century, and international panels of scientists sponsored by world governments have concluded that most of the warming probably was due to greenhouse gases." Facts: Most of 20th Century glbaol warming occurred in the first few decades of that century, before the widespread burning of fossil fuels (and before 82 percent of the increase in atmospheric CO2 observed in the 20th Century). If the AP is referring to the United Nations' Intergovernmental Panel on Climate Change, the AP should become aware that the IPCC report itself (the part written by scientists) reached no consensus on climate change. What did reach a conclusion was an IPCC "summary for policymakers" prepared by political appointees. Most reporters quote only the summary, being either too lazy or too undereducated to understand the actual report. This does not explain, however, why reporters don't more frequently interview scientists who helped prepare it scientists such as IPCC participant Dr. Richard Lindzen of MIT, who says the IPCC report is typically "presented as a consensus that involves hundreds, perhaps thousands, of scientists and none of them was asked if they agreed with anything in the report except for the one or two pages they worked on." Lindzen also draws a sharp distinction between the scientists' document and its politicized summary: "the document itself is informative; the summary is not."