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"Temporary full state ownership is only solution:

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Economist Paul De Grauwe, who has been an astute and harsh critic of central bank’s models and priorities, makes a very simple point and draw a conclusion. Banks are not lending to each other out of mistrust. Various measures to increase liquidity and backstop banks have not made them look any more favorably upon their brethren, A modern economy needs a banking system. De Grauwe argues in particular that trying to recapitalize banks while the liquidity crisis is on merely throws money into a black hole. The new equity goes poof when the liquidity worries resurface (as they have, each time in more virulent form). The only way to break the cycle is for governments to take over banks, or a least most of the big ones.

From the Financial Times:

The essence of what banks do in normal times is to borrow short and lend long. In doing so, they transform short-term assets into long ones, thereby creating credit and liquidity. Put differently, by borrowing short and lending long, banks become less liquid, thereby making it possible for the non-banking sector to become more liquid; that is, have assets that are shorter than their liabilities. This is essential for the non-banking sector to run smoothly.

This credit transformation model performed by banks only works if there is confidence in the banks and, more importantly, if banks trust each other. This confidence has now evaporated and, as a result, the model fails. The generalised distrust within the banking system has led to a situation where banks do not want to lend any more. That means that they continue to borrow short but lend equally short; that is, acquire the most liquid assets.

The result is a massive destruction of credit and liquidity in the economy. The non-banking sector cannot borrow long so as to acquire liquid assets that they need to run their business, because banks do not lend long anymore. This risks bringing the economy to a standstill. A depression is looming.

It is important to realise that this liquidity crisis is the result of a co-ordination failure: bank A does not want to lend to bank B, not necessarily because it fears insolvency of bank B but because it fears other banks will not lend to bank B, thereby creating insolvency of bank B out of the blue. Thus bank lending comes to a standstill because banks expect bank lending to come to a standstill.

How to get out of this bad equilibrium? There is only one way. The governments of the big countries (US, UK, the eurozone, possibly Japan) must take over their banking systems (or at least the significant banks). Governments are the only institutions that can solve the co-ordination failure at the heart of the liquidity crisis. They can do this because once the banks are in the hands of the state, they can be ordered to trust each other and to lend to each other. The faster governments take these steps, the better.

Government interventions have consisted of recapitalising banks. These have not worked. The main reason is that they have been triggered by bank failures as they pop up and, as a result, have only dealt with the symptoms. The liquidity crisis is pulling down asset prices in an indiscriminate way, thereby transforming the liquidity crisis into solvency problems of individual banks. The governments, then, are forced to step in and to recapitalise the bank only to find out later that when the liquidity crisis strikes again, the capital has evaporated. The governments throw fresh capital into a black hole, where it disappears quickly.

Central bank liquidity provision, although necessary, has also failed to address the co-ordination failure and has only made it easier for banks to dispose of long assets to acquire short ones (cash). Thus central banks’ liquidity provisions do not stop the massive destruction of credit and liquidity that is going on in the economy.

The recent decision of the US Federal Reserve to bypass the banking system and to lend directly to the non-banking sector by buying commercial paper is a step in the right direction. It allows companies to obtain cash by borrowing long; a service banks do not want to provide anymore. The step taken by the Fed is insufficient, however. The Fed cannot take over all bank lending operations. Only the government can do this by temporarily transforming private banks into public ones. It can then order the management of these state banks to lend to each other.

Such a transformation (call it a temporary nationalisation) will make it possible to jump start the interbank market and allow the normal flow of credit to be activated. Nationalising the banking system is not the only intervention necessary. There is today a general distrust of private debt. This will force the government to substitute private debt for public debt. The Paulson plan does just that. More Paulson plans will be necessary to put a floor on the price of private debt and to prevent a meltdown.

The temporary nationalisation of the banking system and the substitution of private debt by public debt will allow us to reach a new equilibrium. When this happens, a fundamental reform of the banking system will be necessary in order to remain in this benign equilibrium. When this is achieved the governments will be able to privatise the banking system again.

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38 comments

  1. Peripheral Visionary

    Yves, I apologize for the slight diversion, but I think some serious attention is needed to the Treasury’s ongoing process of selecting money managers for the bailout bill. I realize that the process has been set up to attempt to minimize conflicts of interest between the money managers and the interests of the taxpayers, but I simply do not see how there will not be a conflict of interest if the Treasury selects managers who are also managing other portfolios. Pimco is the clearest example; there is simply no way that their management of a taxpayer-funded bailout of fixed income securities will not conflict with their interests in their own portfolio, which has exposure to virtually every part of the fixed income world. I see the potential for corruption and ensuing scandal as being extremely high.

    And it is not encouraging that the head of Treasury, a former Goldman exec, has selected another former Goldman exec–but a junior exec whose quick rise has more than likely left him with a tab of favors to be repaid–to head the program. Goldman has heavy exposure to the world of fixed income, and the fact that two of its former executives are running this program is even more of an indication that we are rapidly headed toward a fox and henhouse situation.

    But to the original topic, efforts to transform the bailout bill into a bank recapitalization effort may meet resistance from the insiders who had their hearts set on the no-strings-attached purchase of securities approach. The money managers who had their sights set on managing a taxpayer-funded $700B fund may not be pleased with the prospect of that money getting diverted to ownership stakes, which would likely reduce the fees and opportunities for manipulation of markets that came with the original plan. If the Treasury has seemed reluctant to accept the British plan, one reason may be that the money managers lined up at the door are expressing their displeasure over a new direction that may be much less lucrative to them.

  2. Nick von Mises

    Oh the unintended consequences of nationalising the banking system! Apart from the obvious (of how do we persuade the state to return the banks to private hands) this runs right into the economic calculation problem.

    How the hell is government going to “order” banks to lend?
    - Dictat that bank must have $x loans made each week?
    - Approve loans to businesses the government likes irrespective of credit quality and demand?
    - Pull loans from businesses the government dislikes?

    This would be a disaster far worse than leaving it alone.

  3. Anonymous

    The Treasury is doing everything to maximize the conflict of interest, or so it appears. These guys should be arrested. Regretfully, the politicians keep quite as they are paid off by the lobbyists. There will be a huge backlash which will cripple banking for a long time to come. Our president will have some calming words for us, I can’t wait to hear, I just need to put on my blood pressure monitor before. Banks should be taken over, equity and bond holders should be wiped out, insolvent banks should be let go under and the more stable ones should be run by the gov for a couple of years until things calm down. Regretfully the geniuses in Washington will not get to this until this spiral accelerates.

  4. Anonymous

    The 1920′s bubble was handled by Treasury Secretary Mellon with a liquidation thesis.

    But having learned from this “mistake”, Treasury Secretary Paulson will handle this bubble with a nationalization thesis?

    Nationalize the banks, the brokers, the insurance companies and all sorts of finance !!

  5. Anonymous

    i see an outside risk to that. the probability might be remote, but its simply that there is a lack of confidence in the govt itself… govt bond auction failing ??? there are signs of that:
    CDS on sovereign names exploding up
    (example 10Y UK above 50bp/annum, 2y italy around 70bp/annum…)
    treasury bond 2015 reopen auction tailing 40bp this week, OLO (belgium) 10y auction failing, JGB (japan) 10y inflation auction cancelled…
    noone wants to buy that…
    if the private sector doesnt want any, only chance is monetization… which should be (very ?) inflationary

  6. tompain

    TEMPORARY nationlisation? Ha! Yes, I’m sure that investors the world over will be very comfortable with the idea that the government is going to just take their private property for a little while, then give it back to them.

    I find it fascinating that people can understand completely that trust and confidence is the root of the problem, and yet think that the solution is to destroy all trust and confidence in the capital markets. If lenders don’t trust borrowers, they don’t lend. Therefore the solution is to encourage equity holders not to trust that they actually have ownership?

  7. Anonymous

    Confidence? It will not return as long as the same criminals are running the carnival. When the current batch of financial “professionals” are making big rocks into little rocks the general public might start to trust the government again, until then everyone knows that the game is rigged and it’s best to stay out of it.

  8. PrintFaster

    Yep, nationalizing the FIRE economy because of its excesses. Great, the Goldmans, Buffetts, real estate agents, and insurance agents all must have their jobs protected by the federal government because they are all too big to fail. Then they run off to $250,000 boondoggles like the AIG executives.

    The worst part is that the excesses all came about because because of stealth nationalization of the housing industry (everyone gets a Fannie or Freddie house), the insurance business (required insurance, insurance for local gov bonds, SIVs and CDOs), and finance because it organized the government’s dream.

    Sick, sick, sick. Is there no one with any character to say that this is stupid. When you are nauseated, you are supposed to get off the merry-go-round, not turn up the speed.

  9. Anonymous

    “The governments throw fresh capital into a black hole, where it disappears quickly.”

    Is that really something new for governments?

    Surely that is the only reason people believe they can help….Because otherwise they would do what private capital has been doing.

  10. David Habakkuk

    nick von mises,

    If statist Swedes could return those banks which had been successfully recapitalised to private hands, why cannot anti-statist Americans?

    There is not a cat in hell’s chance that the Tory government which is likely to win the next UK election will refrain from selling the stakes it is acquiring in the banks at the very first point at which it is in a position to do so.

  11. Paul

    Would you please address why you believe that govrnment insurance of interbank lending wouldn’t work. Thanks.

  12. MarcoPolo

    Yves, I know you don’t favor impertinent comments and I hope this isn’t seen as one of those.

    I’ve been reading your work in an effort to understand those complex and esoteric financial derivatives and the systemic danger imposed by them to our modern economies. I struggle with it.

    Your previous post concerning the problems in Letters of Credit is more in my backyard – though I’m not a banker. Letters of credit are not an esoteric product. Letters of credit are designed to eliminate risk. Eliminate. It has to be among the most conservative of all banking practices. It’s not insurance. It’s not a loan. It’s a guarantee. And the bank who will make that guarantee will be guaranteed its money in return. Guaranteed.

    The only exceptions are the banks who would game the system and there is a whole corresponding bank / confirming bank infrastructure set up to deal with that. I don’t think anybody would accept a L/C on a Nigerian bank. Nobody trusts their guarantees. No bank is willing to serve as a corresponding / confirming bank. The inference in the breakdown of L/C financing is that all international banks see each other as Nigerians. It is the most frightening thing I’ve read about this crisis so far.

    Business runs on trust. The L/C problem illustrates the level of mistrust which is far, far deeper than what any of us might have imagined. That does have to be fixed first.

  13. melpol

    The value of stocks have been dropping for over a year and have lost trillions in value. Many have seen their life savings gone with the wind.But there is still hope that the downward slide will hit a bottom and stocks will rise again.The big question is: Where is the bottom?. The correct answer is that the bottom is zero. The American currency is backed only by faith that it is worth something. If the public loses that faith it is worthless. There was a time when each dollar could be redeemed by gold. If you would rather hold gold, a teller at the bank would exchange it. The dollar was worth its weight in gold. In 1933 it all changed Franklin D.Roosevelt helped pass the law that it was illegal to possess gold. Then the dollar had value only on the faith that it was worth something. My advice to the public is to keep the faith and we shall overcome.

  14. S

    Leverage and colvencyu are thie issues. not confidence. Confidence would suggest that the old equilibrium was sustainable. If the argument is that all this proposed action will simply put a floor hgere, then the argument is really that we are at the appropriate equilibrium – i.e. market clearing price. trust and confidence have masqueraded for fundamentals for quite a while. it is simply untenable to suggest that there is 50% updise in anything considering that the oil that greased the wheels is not coming back. Unless and until the United States, and for that matter the rest of the world, create value add, not productivity gains in the form of longer house and lower wages, the US economy is dead in the water. Perhaps it is time to acknowledge wthat without leverage we have permaenently lower growth rates. The pace of the decline has been aggressive but the destination will reflect valuation , not hope now, confidence or other. It is all noise. The issue is solvency, consumption and income. On all fronts the picture looks bleak near to medium term. As an aside, when the selling is all done and the market becomes reasonably valued with embeedded returns, will people be enticed to come back? The implication is that interest rates will have to be held very very low for a long time to force risk taking. Will it happen? probably not. Also, the shaky fiscal psoition this places the US in, which will be digested when the selling stops will eventually retard this option and blow out the long end. Not good for mortgages and or financings. Yet another impediment to the capex/investment cycle (which may be nature culling the massive stranded capcity in the US presently).

    I know this is far out thinking, but perhaps expensive credit is actually the correct price? Fancy that.

  15. Francois

    I read snarly and incredulous comments with the undertone of “‘Ma! The Socialist wolf is in our backyard…I’m scared!”.

    Yet, I’m waiting to read any proposal (well, apart from the insurance on interbank lending) that would answer the dire emergency we’re ALL in.
    Again, these are extraordinary times. None of us has ever seen a crisis of trust running so deep and so wide. Are we suppose to let things run their course and risk a depression to safeguard ideological purity? To avoid hurting investors’ feelings? Give me a break!

    So, who will take the leadership and break the mistrust barrier? Who are we gonna call? It’s not the market, since the sucker is on strike.

    That leave the go-vermin.

  16. Glory's List

    How would nationalization really help? How could is possibly work?

    The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow.

    Legislators have no more tricks left to use. Wherever they turn, they face the only option they have been avoiding for years: market adjustments of asset prices. Ultimately, there is no way to avoid the necessary adjustments. There is a gigantic cluster of error in the pricing of assets in the US economy and it has been going on for too long. Asset price adjustments cannot be delayed indefinitely by government rescue plans.

    The market has build-in self-correcting mechanisms, but they’re not working? Why?

    See: Feeling Sick or Debilitating Disease?.

    The only long-term solution seems to be: Get the government the hell out of the economy!

  17. Glory's List

    How would nationalization really help? How could is possibly work?

    The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow.

    Legislators have no more tricks left to use. Wherever they turn, they face the only option they have been avoiding for years: market adjustments of asset prices. Ultimately, there is no way to avoid the necessary adjustments. There is a gigantic cluster of error in the pricing of assets in the US economy and it has been going on for too long. Asset price adjustments cannot be delayed indefinitely by government rescue plans.

    The market has build-in self-correcting mechanisms, but they’re not working? Why?

    See: Feeling Sick or Debilitating Disease?.

    The only long-term solution seems to be: Get the government the hell out of the economy!

  18. Frank

    The most obvious source of lack of trust among banks is knowledge of the quality of assets that my bank holds. Perhaps all the banks know that they are insolvent without the smoke and mirrors of what has passed for accounting for some time now. So, the gig is over, and now is the time for reconciling the ledger. Apparently, at the end of WWII, Japan totally wiped the economic slate clean, and started over. Maybe, short of the dreaded liquidation, that is the only solution now.

  19. gotgold

    Yves I propose extending this commentary –

    If even after this the private sector doesn’t change, the Govt should take over all private sector activities “temporarily” and ensure that credit flows into it irrespective of how stupid the business model is. That way private sector will be ‘forced’ to perform business and the public will be happy in general. Also extending that model people can be made to work definite hours and money and energy spent on elections can be reduced by eliminating this unwanted democratic process and have a union of labor leaders to guide the govt thru this crisis. As always this is all just temporary.

    - General Secretary (i mean treasury secretary)

  20. Nick von Mises

    I’m still waiting on an answer to the economic calculation problem. It’s one thing to guarantee existing loans directly (e.g. in the CP market). It’s another thing entirely to choose who to make new loans to and for how much.

    Nationalising banks doesn’t removed losses, it reallocates them to the tax payer at the potential critical cost of producing a run on the national debt. Risk doesn’t disappear it just gets transformed.

    And the guy who said people are seeing their life savings getting wiped out – if you meant the stock market losses then you really need to go back to the economics textbooks. Assets only have value as an income stream (e.g. dividends) or a future liquidation into cash, to then be exchanged for goods. You need a buyer. The stock market price is by the very nature of it’s calculation just a proxy for the possible sales value. The drops right now, or at least a large piece of it, is the belated recognition that the wealth was never there to begin with. People aren’t losing their life savings. They lost them the moment they exchanged cash for stocks, and any rise since then has been illusory.

  21. Anonymous

    back to anonymous who wants to lock up Paulson :) that is me: The other obvious way to solve this is that let the markets take their course: the strong will survive, the illiquid or insolvent will go under:) The markets will drop 70-80 percent, and after a short while (shorter that this current prolonged route) will rise again. This is how free markets supposed to work. and this is the route that politicians avoid to take

  22. Carlosjii

    The REAL only solution

    “An increase in the quantity of money or fiduciary media is an indispensable condition of the emergence of a boom. The recurrence of boom periods, followed by periods of depression, is the unavoidable outcome of repeated attempts to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Dearth of Credit by Ludwig von Mises

  23. Anonymous

    Yves and others:

    Isn’t this the high stakes poker game that is currently being played?

    The banks WANT the taxpayers to assume liability for ALL the risks that they have taken.

    That’s why they are not lending to each other anymore, even L/C’s are now victim of this, it is their end game to get what they want, socialization of the losses.

    They are almost there.

    Shareholders are probably going to get wiped out, see the action in banks shares, but this is just a fringe diversion. The real play is in the bond and CDS market, and the fat cats want to be made whole by the taxpayer.

    This weekend they will probably get what they want, a worldwide full government (taxpayer) guarantee on all (bad) debt.

    It is sad.

    RDO

  24. S

    “This weekend they will probably get what they want, a worldwide full government (taxpayer) guarantee on all (bad) debt.”

    well said. The whole deabte about sharholders and encouraging capital extension is a red herring. This is all about protecting incumbant managements and banks. How can one trust in the market and on the other hand suggest a bank going away would destroy that market. One word: Entry!

  25. Sanjay

    it is time to turn the model upside down. Rather than giving tax payers warrants we should be nationalizing all the banks and giving the debt, preferred and common holders warrants so that they benefit if the losses turn out to be less than anticipated.

    Bottom line is that there were shitty loans made and the piper has to be paid. The only question is who does the paying. Did we learn nothing from the Japanese melt down in the 90′s. The longer we are in denial the worse the problem is going to get.

  26. PrintFaster

    The more that I think about this, the more that temporary ownership is looking more like transfer of repudiation to the currency — backed by government debt– from the repudiated debt of the creditors.

    What worked in Sweden in temporary transfer, may not work on such a large scale. Discrediting the currency is a dangerous game to play and prone to flammability.

    Somewhere in this game is a tipping point. Since currency is backed up by the government’s ability to tax to pay off the debt — currently the US debt is backed up by they ability of treasury to pay off old debt with new, fresher debt — a crisis of confidence of the currency structure world-wide is at risk.

    Merkel has already signaled that Germany will not participate in picking up the pieces of a Eurozone collapse. Without the Bund and the renminbi, there is little chance that this temporary transfer of repudiation will not overwhelm remaining confidence.

  27. Anonymous

    << The temporary nationalisation of the banking system and the substitution of private debt by public debt will allow us to reach a new equilibrium. >>

    I find this amusing. The temporary nationalization of all industrial enterprises will allow us to reach a new equilibrium (GE, GM, Ford, Exxon, Alcoa, Microsoft…)

  28. Anonymous

    What is ailing the markets is that there is no confidence in Treasury Secretary Paulson and his other Goldman Sachs’ buddies to fairly implement the $700 billion dollar financial rescue package. Paulson held a press conference Thursday to cover his butt by declaring that he couldn’t guarantee that his efforts would do any good. That is because he knows his only goal is to protect his pals, the crooks on Wall Street, and if collateral benefits to the economy occur it will be a miracle. Lets not waste good money on bad people, choose someone new to manage the bailout, someone Americans can trust. Paulson must go.

  29. David Habakkuk

    anonymous at 1.17pm.

    What was referred to was the temporary nationalization of the banking system.

    Nobody said anything about the ‘temporary nationalization of all industrial enterprises.’

    It is more useful, at a time of deep crisis, to engage with your opponents’ arguments rather than caricature them.

    anonymous at 3.28.

    Many things are ailing the markets, apart from a lack of confidence in Paulson.

    It is more important to encourage Paulson to go further down the road to turning the TARP into a sensible package than it is to get rid of him at this point.

    There simply is not time to replace the existing team with a new one at this point.

    It may well be that he amply deserves to be tarred and feathered. But the time for that is later.

  30. Amnon Portugaly

    Economist Paul De Grauwe asserts that the non-banking sector cannot borrow long because banks do not lend long anymore, thus bringing the economy to a standstill. De Grauwe argues that the only way to break this cycle is for governments to take over banks, or at least most of the big ones.
    I believe there is a better and quicker way
    Use the first installment of the $350 Billion of the Paulson Plan and set up 10 banks in the US with the explicit purpose to lend to the Non-banking sector. Each bank will be initially capitalized to the tune of $35 Billion each. Sell shares in these banks worth $35 Billion to private investors with warrants to buy out the government shares at say 5% interest on the original government investment.
    With 10:1 leverage, each of these new banks will have some $700 Billion lending capability or some $7 Trillion in total, ten times the Paulson Plan. These banks having clean balance sheets could easily, along with many sound existing banks, provide the credit the economy needs, even allowing for the failure of other banks with broken balance sheets.

  31. Anonymous

    If you nationalize all the banks, GE and GM are gonna scream bloody murder that they have to be nationalized, too.

    If you only nationalize the big banks, does that mean the regional banks are too small to rescue?

  32. Richard Kline

    De Grauwe’s position has been my own since July 07. I’m only glad to hear it articulated by someone with standing to give it more momentum.

  33. Dave Raithel

    I’d have thought someone more adept at bank-speak would have accepted Nick Von Mises earlier challenge to offer a nuts and bolts explanation how nationalized banks would do business. Since no one has, I’ll offer that his counter-argument goes to a straw man. The argument for nationalization is that with new management, transparency will discover who is solvent and who is not, who can lend and who cannot. I wouldn’t expect that the day to day determinations made by loan officers and CP buyers, etc., using the criteria which had till now allowed them to function, would be much different.

    Perhaps by posing the counter as he does, he does lend credence to something less than nationalization as ownership, something more like the Galbreath plan previously given notice by Yves Smith. What’s at issue is a forced reordering of the states of affairs that will keep depositors harmless. The market isn’t accomplishing that, so let an enhanced FDIC see who’s solvent and who is not, assemble and reassemble as necessary to get capital moving again ….

    Of course, all that may be moot if the real economy isn’t just going to generate the wealth which sustains profits. A solvent bank may be no more inclinded to loan to the local car dealer if that bank concludes sales will continue tanking.

    An ancillary point: Arguing with Austrian Economists is probably futile, anyway. It is an hermetically sealed but thoroughly coherent ideology, for which no empirical evidence is ever a disproving observation. Markets “naturally” have cycles, booms and busts (though they’ll argue different policies make them worse or not as bad…) and so, whatever happens in the market, no matter how bad, is ultimately right. It is morally legitimate that individuals may by themselves or in concert with others, by their actions and accumulated wealth, do what makes others worse off; it is not morally legitimate that the rest of us resort to democratic principals when arguing for a different distribution of benefits and harms. It’s that latter point that “nationalization” goes to…

    One last observation: Mr. Von Mises above also informed a person who had lost their life savings these last few days that what was lost was “illusory.” I don’t believe that anyone here can accept this, as there’s no symmetry for the gains: Had this same person got out of the market back when it was in the 13,000s, nobody would say that the chunk of coins in his hands were “illusory.”

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