Welcome Willem Buiter and Mohamed El-Erian to the Banana Republic Club!

The time has come to announce the formation of the Banana Republic Club. Membership is open, with the sole requirement being that nominees correctly discern behaviors in advanced economies that resemble those of corrupt developing countries, which for sake of convenience are referred to as banana republics. Members are eligible to receive a Carmen Miranda hat, although they are not required to wear it.

Brad DeLong has his Ancient and Hermetic Order of the Shrill. Why should he have all the fun?

We broached this line of thought in a post last year, “America: Banana Republic Watch.” Today we have two well regarded economists pick up the same theme, so it seemed time to commemorate this trend.

Readers are encouraged to nominate other candidates.

Since the US of A is likely to get a disproportionate number of citations, some readers may consider comparing America to, say, Argentina, to be disloyal. We refer them to Frederick Douglass:

A true patriot is a lover of his country who rebukes and does not excuse its sins

Put it another way, if someone is obese, we think we are doing them a favor to tell them that throwing out the scale and getting a fun house skinny mirror is no solution.

Now to the nominees. Willem Buiter adopts a take-no-prisoners stance in his post, “The rescue of Fannie and Freddie by Hankie and Feddie.” Buiter has been a frequent and highly vocal critic of the Fed’s response to the financial crisis (including a less than charitable assessment at a Fed-sponsored conference in New York this May).

But the rescue (if one can call it that, since little concrete has happened) of Fannie and Freddie elicits a new level of scorn:

The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics….

The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.

The continuing corruption of the Fed’s mission through its growing use as a quasi-fiscal agent of the US government is deeply worrying. Admittedly, this latest extension of list of eligible counterparties at the primary discount window is small beer when compared to the creation in March 2008 of the off-balance sheet vehicle/SPV in Delaware which houses $30 bn of Bear Stearns’ most toxic assets, all but the first $ 1billion of which represent a contingent exposure of the Fed. If, as I expect will happen, the range of eligible collateral Fannie and Freddie can offer at the discount window is widened in the future, and if the maturity of the loans available to them at the discount window is extended, this latest enhancement of the Fed’s role as a lender of resort will be a further step on the road to the Fed as quasi-fiscal recapitaliser of first resort.

Since 1997, the Fed has long been the least operationally independent central bank in the industrial world. This latest episode suggests its main current purpose is to be an unaccountable quasi-fiscal agent for the US Treasury. If that is correct, the Fed’s capacity to deliver price stability in the future may have been fatally impaired.

Note that the post discussed alternatives for coping with the Freddie/Fannie crisis at some length.

While Buiter enjoys throwing thunderbolts from Olympus, El-Erian, co-president of bond giant Pimco and respected investor and academic who writes from time to time for the Financial Times, typically strives for a cool-headed, analytical tone, and provides sophisticated, nuanced discussions of markets, economic trends, and policies.

However, El-Erian’s previous comment at the Financial Times, a mere week ago, by the standards of his dispassionate style, was positively alarmed, although it did contain a bracing “Fortune favors the brave” speech. This week, in “Crisis and coherence: finance remains vulnerable,” the concern was even more palpable, the mention of opportunity in risk absent, and the comparison to unseemly third-world behavior a noteworthy departure from his normal anodyne stance:

In a few years, we shall look back at this time as one that redefined the landscape of the US financial system and, by association, the workings of global capital markets. The process is inevitably chaotic as it is driven by “crisis management” reactions…. Yet it is possible to make specific predictions.

The financial system is at a crossroads. At current market prices, the system remains under-capitalised despite some $350bn (€220bn, £176bn) of capital-raising over the past 12 months. More over, given the collapse in their equity prices, a growing number of institutions, including such behemoths as Freddie Mac and Fannie Mae, the mortgage agencies, are essentially un able to raise capital without government help. The longer this situation prevails, the higher the risk the financial system will face difficulties in raising other financing critical to day-to-day operations. This would accelerate forced sales of assets into illiquid markets, leading to another downward leg in an already vicious negative spiral.

This realisation drove the recent emergency policy statements from Washington. It is the second time this year that such dramatic announcements were made on a Sunday – a phenomenon historically reserved for developing countries rather than industrial ones. It reflects the understandable eagerness to minimise forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function….

Accordingly, look for the official sector to encourage further capital-raising and work even harder to isolate the most vulnerable financial institutions and limit the negative spillover effects…

This is a practical approach aimed at striking that delicate balance between laisser-faire and government control. Yet it has important limitations. It does not work for large institutions such as Freddie and Fannie – thus the need for Sunday’s announcement of contingent equity and debt financing from the authorities. Also it cannot handle a large number of institutions facing difficulties. It is likely that additional steps will be needed, lest these limitations end up transforming the current economic and financial dislocations into something even more sinister.

Over the next few months, look for the Federal Reserve to face additional pressure to strengthen the emergency liquidity windows for systemically important institutions. Look for Congress to be asked to appropriate funds to support Freddie and Fannie more directly. Look for innovative mechanisms to raise additional capital for the financial sector through public-private partnerships. And look for other fiscal stimulus measures to counter the increasingly vicious spiral in housing and, soon, consumer demand.

Many of these steps involve distortions to the efficient functioning of markets over the longer term. Implementation is difficult and, in the absence of strong leadership, may not be timely enough. Yet the cost of doing nothing may be even higher. The key is whether all the ad hoc crisis management steps eventually evolve into a coherent and sustainable policy outcome. The jury is still out on this.

In other words, brace yourself for the officialdom making things up as they go along and hope they go to the trouble of cleaning it up later.

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  1. Jojo

    “In other words, brace yourself for the officialdom making things up as they go along and hope they go to the trouble of cleaning it up later.”

    Ha, ha, ha! That’s good Yves. Bushco has been making things up for nearly 8 years now. Does anyone really thinks that the Bush admin gives much of a crap what happens in the future?

    As Billie Holiday sang in God Bless The Child:
    Them thats got shall get
    Them thats not shall lose
    So the Bible said and it still is news
    Mama may have, papa may have
    But God bless the child thats got his own
    Thats got his own

    Bush & friends GOT THEIR OWN. They don’t care. They’re just hoping to keep everything afloat until they can turn the mess they created over to the next guy.

  2. Anonymous

    “Yet the cost of doing nothing may be even higher.”


    All this stuff about the Fed specifically becoming overinvolved in credit risk is overdone. Clearly there is fiscal risk any any government support, and clearly the Fed is working with Treasury to structure the support components and get approvals from Congress. This is obvious from the Fannie Freddie support structure. What does it matter in the end if the Fed liquidity facility includes some credit risk? The bearing of the risk between the Fed and Treasury is irrelevant to the taxpayer in the end. What does it matter in the end whether the credit risk exposure is in the Fed’s liquidity facility or the Treasury’s capital facility? The Fed is sterilizing its asset activities and will continue to do so, so the direct monetary effect isn’t an issue, which is its ultimate mandate. And since when is any liquidity facility without some credit risk? And the Fed hasn’t even breached its own collateral eligibility requirements yet. Too much fretting about the Fed component here. The system is in a depression threatening mess and fiscal risk is unavoidable as per the above quoted admission. What’s the real value in the nit picking between Fed and Treasury exposures? Particularly when the Fed’s control over bank reserves and the Fed funds rate hasn’t been compromised?

  3. Anonymous

    Gotta laugh at jojo’s comments. Both parties are guilty in this crisis. As somebody whoi lived in DC and worked in the real estate and mortgage loan fields for many years before retiring in 1996, I saw first hand this mess in it’s creation. Let the bond/loan pool holders eat it and be wiser next time.

  4. Independent Accountant

    Zimbabwe Ben rides to the rescue with his magical printing press. The bottom line: get out of dollars now. Got gold? Get more.

  5. DownSouth

    The hypocrisy is without bounds.

    In the case of a Banana Republic, the U.S. would already be sending in the ball busters. The demand would be for zero growth in the money supply, massive cuts in government spending, more privitization and less regulation.

    Dr. Jekyll and Mr. Hyde, as Carlos Fuentes calls it. What is good for the goose is definitely not good for the gander.

  6. David Pearson

    The Banana Republic moniker carries more important than its facetious tone implies.

    I wager that 90% of bears are deflationists. They argue that with an economic collapse come low inflation and low interest rates. Exhibit A is the Great Depression. Exhibit B is post-bubble Japan.

    Exhibits A-Z, and then some, for the inflationists, are the emerging markets. There, inflation and depression have cohabitated with the regularity of a married couple.

    Is the U.S. a Banana Republic? If so, then its sovereign risk premium should be rising, no, rocketing higher. Adding high interest rates to the already toxic credit crisis mix means…oh well, it means we are all too bullish.

  7. russell1200

    I am not so sure about the Banana Republic analogy.

    Fannie and Freddie (at least according to Tanta) were sent their private little way to get the government debt off the books: a response to the Vietnam War run up in debt.

    So this time we are having our expensive little war(s) and bringing the debt back on the books.

    The US Government tried to grab a large junk of the Middle East’s oil supplies and buy up the entire US housing stock (at inflated prices) at the same time. Many in the rest of the world appear to have thought it was a good idea – they did buy the debt after all.

  8. Francois

    “Yet the cost of doing nothing may be even higher.”

    Higher now, yes. What about long-term? Not the long-term “we’ll all be dead” type, but say 5 to 10 years?

    How much holes in the dyke can be patched before the dam brakes and we get flooded?

  9. John

    At what point does the Fed collapse over all this nonsense. Do the market take it out on the dollar?

  10. Mara

    I’d say for Freddie and Fannie to declare bankruptcy, trash the shareholders first, long before I go looking for taxpayer money. Then re-org, if possible. I do believe we live in a generalissimo banana repub, but I really liked the “Zimbabwe Ben” moniker.
    I think we should abolish the Fed as well. Even living under Tony Soprano’s vig would be less painful than this setup.

  11. Lune

    If you check out the origins of the term Banana Republic, the analogy becomes even more apt, I’m afraid.

    Talk about being hoist on one’s own petard. The term Banana Republic came from American fruit companies becoming more powerful than their host countries’ governments, forcing the “Banana Republics” to serve American corporate interests over the interests of their own citizens. Now that the American firms have finished off Central and South America, they have started feasting on our own country.

    Chiquita Banana, Goldman Sachs. Is there much of a difference?

  12. Juan

    True enough Lune.

    I happened to live in the classic ‘banana republic’ (Guatemala) for a number of years, returning to the states just in time for the early 1980s double slump. By the mid or later 1980s I recall thinking “we are becoming Guatemala and it’s suffering still more undevelopment”.

    The thought arose not simply from the weak economic performance but the increasing ‘casualization’ of the labor market here in the U.S. on one hand and greater concentration of capital on the other, with both being facilitated through state policies.

  13. Laughingsong

    David Pearson said:
    “Is the U.S. a Banana Republic? If so, then its sovereign risk premium should be rising, no, rocketing higher.”

    And Russel200 said:
    “Many in the rest of the world appear to have thought it was a good idea – they did buy the debt after all.”

    I guess it just goes to show that trust is “sticky.”

    — Laughingsong

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