Wolfgang Munchau: Policy Errors Risk Turning Credit Crunch Into Depression

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.

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  1. S

    “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”

    How exactly does one reverse the law of gravity? While the writer makes excellent points regarding wasting resources on second raters, he is way off the mark on inflation. The statement on halting deflation implicitly assumes that credit is infinitely available and people are infinitely stupid. The later may be so but the prior reality resides only in BB head.

  2. Anonymous

    The bailout plan did not come from Paulson; it came from the neo-cons in the White House that wanted to use this crisis to load the Federal government up with Wall St red ink to kill most of the Federal Governments social programs.

    You have to remember these are the same people that pushed us into the Iraq war for ideological reasons.

    Now I have no respect for Paulson’s capitulation to the White House but the bail out was not his idea.

  3. vlade

    Yves, on the policy failure:
    I’ve had a chat with our funding guy today, and he believes that there’s a very large policy problem with BoE/FSA funding rules at the moment.
    To put what he told me (someone might be able to put it better, or correct me..):
    In normal circumstances, banks were required to be cashflow positive for approximately a next week. That meant while they couldn’t fund themselves overnight (because you don’t know that you can roll that loan overnight), they could fund themselves with anything over one week – two weeks, month, two months, three months…
    Last year, when the system started showing first signs of stress, these prudential rules were increased to 28 days. In effect, it killed any but two and three months funding, and the only funding you used to get with any sort of liquidity used to be three months funding.
    In the recent months, almost any but the recent funding has disappeared. All the money that used to lend on the short term maturities (1 week – 12 months) effectively got concentrated into O/N funding. Yes, BoE now provided (first time this week) 3 month facility, but imagine all the banks fighting over the puny 40 billion of funding! On the other side, there’s so much money in O/N that banks deposit money with BoE, because they can’t find takers! (this seems to be the case with ECB too, as the amount of O/N loans is about 2/3 of the O/N depos).
    So, my colleagues reason, if we’re throwing all the rules out of the window, why not throw the long liquidity requirement too?
    I’d really like to see some more qualified opinions on this…

  4. Anonymous

    Question for all you big star traders:

    I’d like to move some money to one or more equity mutual funds. I’d been in cash and TIPs since mid 2005. Which equity mutual funds do you think of as having the most rigorous discipline and conservative approach? Anyone other than FPA?

  5. Anonymous

    The terrible banking bailout plan by Treasury Secretary Paulson and Fed Chairman Bernanke is rejected by the stock market, since the bill’s signing the markets have crashed by – 1,586 points. Americans do not trust Paulson, a tool for the Wall Street firm Goldman Sachs, and Bernanke, an ivory tower academic who is experimenting with the US economy in an ad hoc way so that he can write papers when he returns to Princeton. We need people at the top that Americans can trust, Paulson and Bernanke should resign, now.

  6. realty-based lawyer

    It’s possible there’s some positive leverage in the Paulson plan, through the backdoor effect of fair value accounting. As I read FAS 157, the SEC/FASB interpretation and the recent FSP, prices under the auction program could be used as “market” prices or inputes for Level 2/3 assets. If so, even financial institutions that don’t participate in the auction program could revalue their portfolios based on the higher-than-current-market prices resulting from the auction. Which would help recapitalize them (and also, of course, help preserve them from having to participate in the direct-purchase program, with its restrictions on executive compensation and warrants for the taxpayer). That collateral benefit would mean the overall effect would be greater than 1-to-1.

    Which doesn’t mean I like the TARP. Another effect is that the government would be the only market, no private party being willing to pay over what it believes market is; a third, that the new values would lack credibility and so would fail to increase transparency or instill confidence. Both of which, in combination with the maxing-out of the consumer who constituted over 70% of the economy, suggests that credit would not begin to flow again. And the real economy would therefore not benefit, but would instead be burdened by TARP-related expenditures (and, eventually, losses).

    I agree that the intention (and first and most powerful effect) was to help GS and other Wall Street banks. In that, I believe TARP will succeed. A fine feeding frenzy is starting.

  7. Anonymous

    Right, Wolfgang is the only one who knows about the parallel banking system. Hank Paulson, who ran the largest firm in that system, could really use Wolfgang’s help.

    These pompous windbags who think they are the only ones who understand anything and everyone else is just a moron are very tiresome and completely lacking in credibility.

    Euro”Intelligence”? I don’t think so.

  8. wintermute

    Events continue to move on. Is this how the US dollar may lose its reserve currency status – through force majeure?

    Central bankers consider using their own FX reserves to satisfy the global dollar shortage caused by the Credit Crisis deleveraging.


    When this is over will they be replenishing all those dollar holdings – or speed up diversification into other currencies and equivalents?

  9. Anonymous

    “Then why has Paulson been so incompetent, anonymous?”

    Paulson has been extremely competent in pursuing his apparent objectives. He destroyed Goldman’s rivals and got legislative authority to help Goldman by buying up its dodgy debt at a premium.

  10. Anonymous

    “Paulson has been extremely competent in pursuing his apparent objectives. He destroyed Goldman’s rivals and got legislative authority to help Goldman by buying up its dodgy debt at a premium.”

    And lest I forget, he also pumped up the price of the Goldman stock in his family foundation, and his wife and kids trust funds.

  11. Anonymous

    Get ready the depression is coming and the will be followed by hyper-inflation. They can’t stop this.

  12. FairEconomist

    There *is* an important reason for the bailouts. Because of the CDS system, one collapse can possibly take down the while system, and because it’s completely unregulated and unsupervised, policymakers can’t even know for sure which ones are dangerous. That’s also why we can’t let the shadow banking system die a richly deserved death.

    Whatever short-term patches we use now, unwinding the CDS tangle is a top priority. One suggestion is that CDS owners must own the underlying bond. Whatever fix we choose it needs to be quick. As Eurointelligence points out, saving a bad institution is very expensive. We need to shut down the mechanism the institutions blackmail up with.

  13. Anonymous

    “That’s also why we can’t let the shadow banking system die a richly deserved death.”

    It is easy to save the system and punish current management and shareholders. Nationalize anyone that the FDIC believes is insolvent or in danger of becoming so. Inject new equity funding.

    In addition, the government could freeze the derivatives market by making any transactions a felony, punishable with prison time and fines based on net worth. After the derivatives market was frozen, the government could unwind the trades. And start regulating them like insurance contracts, to eliminate undercapitalized players.

    I’m tired of people saying there is a crisis, so we must hand out free money. That is obviously wrong. If you are smart, and really want to do something, there is often a way. Of course, Paulson really does NOT want to hurt wall street because it would hurt his mutual funds and his foundations and kids trust funds holdings in goldman sachs, as well as his prospects for getting work as a board director or consultant for banks.

  14. Richard Kline

    Yo Wolfgang and Eurointelligence, thumping arses and taking names!: more of it. We need pressure on the pols to get it right and do the right thing.

    The first moves in a crisis are almost always wrong; we see that here, but it’s a truism. First moves are conditioned responses. Conditioned responses map to prevailing conditions, i.e. ‘the box.’ Crises blow out or collapse fundamental parameters of the box. Thus, by definition first moves get the transformational conditions wrong, and so bungle. If we could get policy makers to see this, we _might_ get better policy. But there is the parallel issue that major public policy ventures, especially financial ones, are as much about ‘signal’ as about ‘substance.’ Policy makers know that much of their power is in signaling, so they give the signals which are expected in prevailing conditions; not to do so would decrease their initial advantages and confuse participants. it’s a double bind of a kind. What we need are Solon’s who stay current, and anyone with that kind of ability isn’t going to be in the public sector when they could be raking it in on their own. Just the way of the world, my friends . . . .

    Hey, Vlade, good to see yah. I’d been worried that the zombies et your fund since you’d gone quiet. I’ll chew over your questions later, and squawk if I have three cents worth of opinion to rub together. Now, I have to get ready to go to work. The world may (seemingly) end, but life and labor trudge onwards.

  15. Anonymous

    The Credit Default INSURANCE market (swaps is a word chosen to avoid proper regulation) should be forced into the open and into a transparent Highly Regulated clearing market.

    Real Soon.

    EVERYONE’s dirty laundry, out of the closet, on to the auction block.

    Why won’t this happen?

    The useless parasites who cooked up this Ponzi would be exposed. This would include Many Notables Nobles in finance and politics.

    Not good for them.

    The lynch mobs could spot them much easier.

    Most CD(i)s are worthless. Big losses, chain reactions, lost weekends in the Hamptons, gone, gone, gone…

    The Dawn came Up like Thunder

  16. Yves Smith

    Anon of 4:19 PM,

    Palley is calling for much broader support, although I cannot imagine how you sell that politically. The measure you pointed to is limited to depositary institutions and bank holding companies and permits them to buy asset backed commercial paper from money market funds. This appears redundant given the money market fund guarantee program, although participation in the latter is not certain.

    And the other measure, to purchase agency discount notes, is again narrow, focused on a particular instrument. Palley’s point is the powers that be need to backstop players, not asset prices.

    Anon of 5:55 PM,

    Unfortunately, outstanding credit default swaps cannot be migrated to an exchange. They are far too heterogeneous. The industry needs to standardize terms, and then newly created CDS could be exchange traded.

  17. Owe Jessen

    I think it’s hard to refute Wolfgangs points, but my impression, from the number of highly publicised contacts between european and us heads of government, that a coordinated international response to the crises is being finalized – hopefully with the right response this time.

    What I find hard to stomach is the impression one has to get that the politicians are ignoring all evidence from prior financial crises about the right, necessary steps towards a solution.

    Just as a thought, could one adopt the Obstfeld-model of currency crises to the situation, and the politicians still feel that a regime switch still is costlier than doing nothing? If so, it obviously is a myopic view.

  18. Anonymous

    “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 [(price)] deflation”.

    Isn’t using TOO MUCH DEBT so that price deflation didn’t happen what got us into the current mess and the Great Depression?

  19. Anonymous

    “someone” must have an algorithm on this, no? somebody somewhere must have written one. bear market + global crisis – fed bailout / xxxx = ??????? my bets are on the algorhythmists… (sorry for the pun!)…

    get us outta here already!

  20. Anonymous

    “Thomas Palley is (more critical of US policy because) it has focused on the traditional banking system, and has failed to address the escalating crisis in the shadow banking system.”

    Oh, have mercy on me. I have cried for investment banks, Fannie and Freddie, AIG, and the banking system. I am drained. I have no more tears left to shed for the pitiable folks of the shadow banking system. Have a nice day.

  21. Anonymous

    10:05, you display your ignorance. Palley is a screaming liberal, no fan of the elites. He is about the last person who’d shill for investment bankers. A financial collapse hits the poor harder than the rich. You need to bone up on the Depression and the Asian crisis.

  22. Anonymous

    Anonymous 10:46 says that “Palley is a screaming liberal.” I am confused what liberal (or conservative) means anymore.

    I am glad you understand what caused the Great Depression. There are so many conflicting opinions on the topic and, frankly, many of them do not make sense. Maybe you can enlighten the ignorant among us. Was it too much government interference? Or not enough? Was it because they did not bail out the “shadow banking system”?

  23. Anonymous

    This is 10:46, I said nothing about the causes of the Depression, I am puzzled you attribute anything of the sort to my statement. Someone basically accused Palley of being an apologist for investment bankers and hedgies. If you knew his background and writing, you’d realize that charge does not stick.

    The reference to the Depression and Asian crisis was to their effect on the poor v. rich.

    Did you not read what I wrote? Or are you choosing to twist my words?

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