Wolfgang Munchau in EuroIntelligence argues against conventional wisdom, which is that modern policy tools and institutional arrangements will keep the credit crisis from morphing into a depression. He contends that the policy errors, the result of political considerations, have been substantial. He also says that Treasury Secretary Henry Paulson devised the badly-flawed Troubled Assets Repurchase Program to benefit Goldman. Although this is a widely-held view, few financial commentators have been willing to say so in writing. He also discusses how EU member nations are wasting firepower rescuing institutions for competitive reasons when they should have been allowed to fail.
Thomas Palley is even more critical of US policy, arguing that it has focused on the traditional banking system, and has failed to address the escalating crisis in the shadow, or in his usage, the parallel banking system. Key sections:
The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years….
In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.
Though the parallel banking system engaged in riskier lending than the traditional banking system, those differences were a matter of degree. Traditional banks like Washington Mutual, Wachovia, and Citigroup have also all lost huge sums. However, the traditional banking system is more protected for two reasons.
First, traditional banks are significantly funded by customer deposits…Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans…
The bottom line is that the banking system is in better shape not because of its virtues, but because of policy…
Policy has therefore ring-fenced traditional banks. But in the meantime it has left the parallel system in the cold, leaving a gaping hole in the policy dyke…
The urgent implication is the Fed (and other central banks) must extend its safety network to include the parallel banking system. Just as the traditional banking system needs liquidity assistance, so too does the parallel system. That assistance can be provided through such vehicles as the discount window and Federal Reserve auction facilities, and it should be allocated to qualified firms able to post appropriate collateral.
A credit based system is a chain, and a chain is only as strong as its weakest link. The Federal Reserve’s antiquated view has it protecting links connected to the traditional banking system while neglecting everything else. That is a recipe for failure.
From EuroIntelligence (hat tip reader Saboor):
This was always a tough crisis to handle, but if we had responded to it in an appropriate and forceful manner, the worst could have been avoided. The problem is that we are making all sorts of policy mistakes now, very serious mistakes. Unless reversed with a weeks at the latest, they will lead to a situation that truly deserves the epitaph of a global meltdown. We would no longer be talking about the worst financial crisis since 1929. It would simply be the worst financial crisis.
Everybody knows the mistakes of the banks, the regulators, or the rating agencies. Now governments on both sides of the Atlantic are committing perhaps even bigger mistakes. It seems that even in times of severe crisis, their main priorities are about short term political gain. The US administration’s TARP proposal is a case in point. It has lambasted by almost every economist, including those who normally disagree with each other on most things. Buying up toxic securities at above market prices is simultaneously the most expensive and unfairest way to recapitalise the banking system. It is very difficult to believe that the US treasury secretary can possibly be driven by a motive other than a wish to benefit the investment banks he once chaired, and which stands gain handsomely from such a package, and which would never dream of accepting any government capital infusions. The only alternative explanation for his behaviour is immense stupidity – and I know that he is not a stupid man.
Over here in Europe, the policy response is just as bad. The Germans have been bailing out institutions such as IKB Bank with no systemic relevance whatsoever. The same actually goes for Hypo Real Estate. Its policy relevance is purely to secure Germany’s leadership in the market for Pfandbriefe or covered bonds. In other words, the Germans are bailing out to secure or maintain a competitive edge against other euro area countries. That’s also behind the Irish rescue programme. Ever the good Europeans, the Irish only care about Dublin’s status as a European finance centre. We should not be surprised that Germany stubbornly rejects the idea of euro area wide, or EU wide, bailout scheme. Such a scheme would certainly have to be much better managed. It would be symmetric, perhaps even model-based, as it was the case during the Swedish financial crisis in the early 1990s. The Germans fear that they would lose out, as the EU would almost certainly not rescue the rotten Landesbanken, or other institutions through which the political establishment exercise undue influence.
Financial crises do not automatically produce recessions or depressions. Only bad policy cab turn a crisis into a catastrophe. The 1930 Great Depression could have been avoided if governments had not pursued pro-cyclical policies, and most important, if central banks had not allowed deflation. We have learned from those mistakes, but are committing new and possibly bigger ones. Government is our one and only safety net. It could, if it wanted to, provide basic financial services, that could easily fulfil three economic functions that are attributed to finance: to provide liquidity, to share risk, and to allow agents in the economy to make inter-temporal choices. You don’t need CDOs and CDSs for that. A network of central bank branch offices, in combinations with a relatively small number of national, or nationalised banks, could temporarily offer the vast bulk of all financial service of wider economic relevance. The way to go is to shrink the financial system and nationalise the systemically important financial institutions. I have heard there are about 45-50 in the euro area though this is not a precise guess, and subject to change over time. After the financial sector is stabilised, it is time to rebuilt the system, to allow the government later re-privatise its assets, ideally subject to different incentive structures than those that have led to this crisis. In theory, governments could even make money on it. I doubt it. But at the very least, governments can minimise losses.
But if you squander valuable resources on second-rate institutions such as Hypo Real Estate, for the wrong reasons, your freedom of manoeuvre will be constrained at the moment you need it the most, for example, if or when the German government was called upon to save Deutsche Bank, Allianz, and a couple of Landesbanken on the same day – probably a Sunday. The reason why we need a European, and perhaps even a global plan, is that this is the only way to do this if things get really serious. This is also why investors should completely disregard promises by government to offer infinite deposit insurance. If the German banking system were to collapse, the German government would have to issue bonds to pay for half a trillion euros of deposits, Germany would not be in a position to do so. Its sovereign rating would converge towards the equity tranche of a subprime CDO.
The whole gist of the German government’s policy consists of a bet that the wider public remains infinitely stupid and ignorant. This bet it will lose.