Monday, November 26, 2007

It's Worse Than You Think

"Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. ... Moral hazard fundamentalists misunderstand the insurance analogy, fail to recognize the special features of public actions to maintain confidence in the financial sector and conflate what are in fact quite different policy issues. As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crisis and increase economic instability. ... Second, the insurance analogy fails to take account of what is a key aspect of the financial context--moral hazard and confidence are opposite sides of the same coin. ... But much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off", Larry Summers (LS), at, 23 September, post titled, "Beware moral hazard fundamentalists".

"Three months ago, it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability. ... Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. ... Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. ... Then there are the potentially adverse effects on confidence of a sharply falling dollar. ... First, maintaining demand must be the over-arching macroeconomic priority. ... The priority now has to be maintaining the flow of credit. ... On the information available, the 'super conduit' has worrying similarities with the Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps, there is a strong case for it, but that case has yet to be made. Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible", LS, at, 25 November, post titled, "Wake up to the dangers of a deepening crisis".

Who is LS? Winner of 1993's John Bates Clark Medal in Economics, nephew of Paul Samuelson and Kenneth Arrow, both Economics Nobel Prize winners, the youngest man ever to get tenure as a Harvard economics professor. What a pedigree! He was our Treasury Secretary and worked under Robert Rubin (RR), now at Citigroup as Undersecretary of the Treasury.

What do I make of this? The parade of horribles! Reduce efficiency! Wow. If there are no costs to be imposed on taxpayers, let the private sector do it. I'm sure, you guessed it Goldman Sachs (GS), will find a way to profit from the crisis. With geniuses like LS, RR, and Hank Paulson (HP) at work, GS can't miss. Oops, HP nominally is in the public sector now.

LS first piece is primarily an ad hominem attack on those he expected to disagree with him, likening them to ignoramuses who want to return to the "old time religion". Should LS call me a "hell fire and brimstone" policy proponent, he will not make me change my mind. The title doesn't scare me. Consider, LS first piece was printed 17 days before HP suggested MLEC. This indicates HP used LS to write a "set up" piece to discredit those expected to oppose MLEC. Now that MLEC looks like it will fail, LS is free to attack it. What are banking's special features that make it immune from moral hazard? In fact, banking is more given to moral hazard as the banks issue money and get reserves from the Fed. Why must "public actions [be made] to maintain confidence in the financial sector"? Why don't the $50 million a year geniuses who run these institutions run them prudently?

LS second piece attacks MLEC. Why not? None of the "wise men", including RR, former Treasury Secretary has devised anything else to protect the banks. LS mentions the falling dollar once in the piece. LS wants to maintain demand, and favors a "comprehensive approach ... to maintaining demand in the housing market". My idea: let all 105 milion Mexicans into the US. That also solves our illegal alien problem. We get one "comprehensive" solution to two problems. What a bargain! The US is overinvested in housing now. We don't need to maintain housing demand. We need large financial institutions to fail, or else the dollar will. We have a shortage of savings and LS wants to "maintain demand". Wild!

LS now sees the situation is "much more serious" than he thought it was a few months ago. Where has he been? Enough. My question: got gold?

What may be panicking the powers that be is: the bond insurers may all be downgraded. "Some veterans on Wall Street are now questioning the viability of their business model", Tomoeh Tse, at, 24 November.

I never saw bond insurance as a viable business, see my 30 October, 5 and 18 November posts.

Yves Smith has a nice post about LS piece at, 26 November.

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