Bailout Theory
I have a theory on the economic bailout plan that’s being proposed in the states. Disclaimer: I know as much about economics as I do about fixing cars, and I’m all proud that just last week I changed the headlight bulb by myself.
Here’s a quote from Dave Winer with some back story:
Now we have … Henry Paulson, who says there’s impending doom, but he can’t say exactly what it is, it’s not security this time, but fear of starting another level of bank runs. Senators and Representatives come out of a Thursday night meeting with the secretary … won’t say exactly what he said, but they are stunned. The next day buried in a sea of press about this event is an almost innocuous paragraph in a NYT piece that talks about a flight to safety from the US Treasury money market. OMG
So basically, there’s a secret threat to the economy that increases the urgency for a bailout. What could this be?
My theory is that big foreign investors, say the Chinese or the Saudis, who have heavy investments in US banking and mortgages, have given the US an ultimatum: Bail this mess out, or we’re pulling out.
That truly would collapse the US banking system.
September 23rd, 2008 at 8:33 am
I don’t think it’s that huge of a secret. From the Wall Street Journal: “Instead, investors flooded the safest investment they could find, short-term government debt. This drove the yields of short-term Treasury bonds to zero, meaning investors were willing to accept no return on their investment if they could guarantee getting their money back.”
I’m as much of an economist as you are Steve (and even less of a mechanic - I bring my car in to get light bulbs replaced), but I’m pretty sure that no one wants to see their “safe” investments in government bonds have a 0% yield. The same article (”Shock Forced Paulson’s Hand”) talks about the potential collapse of money markets - another really bad thing, because they aren’t supposed to be able to collapse.
However, I don’t think that China (or the Saudis, but I don’t think they’re on par with the Chinese) have that much clout. Chinese investors are in the same position (or arguably a worse position) than average Americans - if they precipitate a crisis by trying to pull all their money out there will be a definite collapse AND they won’t get their money back anyways (when banks collapse people lose their money). Plus they will have destroyed the biggest market for their goods, since people with no jobs in a depression don’t buy cheap “Made in China” nick knacks on the same scale as affluent people in a booming economy.
I don’t think the threat is that secret - if banks start to collapse, a lot of other companies follow suit - because they can’t get money from the banks to pay their creditors or their employees. Look at our own company: Adobe has lots of money, but it’s not a big pile of cash sitting in Shantanu’s office: it’s in investments in banks. If the bank that has the bulk of Adobe’s money collapses, how does Adobe get it’s money out? Where does it get the money to make payroll in 2 weeks? To pay rent on our building? That’s what happened during the crash of 1929 - people panicked and tried to withdraw all their money from banks at the same time. There wasn’t enough money and the banks collapsed, in which case no one got their money, since the bank that had it was gone.
I don’t think there’s a big secret to what’s going on. I think that few people realized the depth of the problem and also that in a free market, it’s hard to predict what’s going to happen in reaction to certain actions.
That article goes on:
“In three days, the Fed had pumped hundreds of billions of additional cash into the financial system. But instead of calming markets and helping to suppress interest rates, short-term interest rates had gone haywire. Most strikingly to some Fed staff, its own federal-funds rate, an interbank lending rate managed directly by the central bank, repeatedly shot up in the morning as banks sat on cash. The financial system was behaving like a patient losing blood pressure.
Bracing for Redemptions
Fed staff discovered that one reason the federal-funds rate was behaving so abnormally was because money-market funds were building up cash in preparation for redemptions, leaving hoards of cash at their banks that the banks wouldn’t invest.
U.S. depositary institutions on average held excess reserves of $90 billion each day this week, estimates Lou Crandall, chief economist at Wrightson ICAP. This is cash the banks hold on the sidelines that does not earn any interest. That compares with an average of $2 billion, he says, noting he estimates banks held $190 billion in excess cash on Thursday, as they feared they’d have to meet many obligations at the same time.”
Basically, the Fed took action (pumping more money into the system) to try to stave off disaster - but the system didn’t react how it was supposed to (calmly resume normal functioning with the security of the extra cash). Instead of using the extra cash in normal operations, banks sat on it - so that if all their customers demanded their money on the same day, they would have the cash to pay and not collapse. This is the type of thing that happens in inherently chaotic systems made up of millions of parts working separately. You can’t predict what will happen.
And I think this is what scared the government so badly. It’s pretty much textbook theory that the 1929 crash could have been staved off if the Fed had made more money available (like, essentially printed more cash). I believe that the economists at the Fed thought that the same solution would work now - but it’s not working because it’s a different (bigger, more complex) system now. I think that they are really, really scared because no one knows what’s going to happen - and some of the things that *could* happen would be really, really, really bad. Really. (It scares me a lot actually.)
So the government is starting to panic (which is not an unwarranted thing - the situation seems pretty scary to me too.) I think the situation is plenty scary enough (another depression like in 1929?) without needing to invent foreign threats to add urgency.