Why the French are to blame for the banking crisis

Uwe Reinhardt explains. I note with favor that Reinhardt offered a solution similar to what I was peddling last year: rather than bailing out the banks that got us into this mess, the government could take the same money and create new banks that would keep lending going. (I proposed using existing entities like the Federal Reserve, Small Business Administration, Department of Education, etc. to keep loans flowing in vital areas of the economy. I also proposed capitalizing healthy banks that had kept their noses clean during the boom. But it amounts to essentially the same idea.)

Credit spreads

Recent movements in credit spreads (here the difference between yields on Baa and Aaa corporate bonds) tied to the Greek crisis are cause for concern:

But so far it's nothing like we saw two years ago:

The Baa-Aaa spread is important because it captures financial market participants' attitude toward risk. An increase in the spread means investors are shying away from risky securities and hoarding safe securities instead. This means that corporations face higher borrowing costs, which could reduce investment spending. It also reflects a general worsening of the psychological climate, which could mean lower spending across the board.

This is what people mean when they talk about the "headwinds" facing the economy as a result of financial stress. As I said in an earlier post, we're in a race between the forces of expansion and financial stress. Real economic expansion relieves financial stress - e.g. although Greece might still be having trouble servicing its debt if the world economy was not in recession, the other PIIGS (Portugal, Italy, Ireland, Spain) would be doing just fine. But financial stress retards economic expansion for the reasons given above. My money is still on the forces of expansion, but the increase in credit spreads has the potential to turn into something serious.

Greece fire (is that what we're calling it now?)

Europe's attempts to stem the Greek debt crisis haven't calmed interbank lending markets. The TED spread (LIBOR minus Treasury bill rate) has poked up above 30 - well below the crisis levels of 2008-09, but troubling nevertheless.

The NY Times assesses the danger this poses for the European and US banking systems. But the article's focus on the dangers of public debt is misguided:

The European rescue plan, totaling 750 billion euros, is intended to head off the risk of default but would vastly increase borrowing. That could hamstring Europe’s nascent recovery.

Indeed, it was too much debt that caused the problem in the first place: a new report by the International Monetary Fund warns that “high levels of public indebtedness could weigh on economic growth for years.”

The world’s budget deficit as a percentage of gross domestic product now stands at 6 percent, up from just 0.3 percent before the financial crisis. If public debt is not lowered back to precrisis levels, the I.M.F. report said, growth in advanced economies could decline by half a percentage point annually...

After borrowing trillions to stimulate their economies and ease credit concerns during the last wave of fear in late 2008 and early 2009, governments cannot borrow trillions more without risking higher inflation and shoving aside other borrowers like individuals and companies. Short-term interest rates, already near zero in the United States, cannot be lowered any further. And vital steps like raising taxes or cutting spending increases could snuff out the beginnings of a recovery in northern Europe and worsen the pain in recession-battered economies like Spain, where unemployment recently passed 20 percent.

With the exception of wartime, “the public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution,” Willem Buiter, Citigroup’s top economist, wrote in a recent report.

“Restoring fiscal balance will be a drag on growth for years to come.”

Though excessive public debt in Greece and possibly Portugal, Spain, and some other countries, is clearly the root cause of the problem, the high levels of debt in the US, Germany, France, UK and other large economies have little to do with it. As Paul Krugman notes, according to the IMF report cited in the article the reason debt has exploded in these countries is a decline in tax revenues due to the recession, not excessive government spending. (The report also makes the specious claim that the financial crisis has caused a permanent reduction in potential GDP.) Attacking deficits now would be the height of insanity: we need continued fiscal stimulus to maintain the recovery and put us in a position where we can begin to restore fiscal balance in a few years.

Near term, the ECB needs to learn a lesson from the Federal Reserve's success in the US and begin a program of quantitative easing focused on purchases of sovereign debt. Fears that this would be wildly inflationary are crazy - at any rate, Europe could use a dose of higher than normal inflation at this point in time to ease the adjustment of countries like Greece.

Sometimes the conventional wisdom is right!

William Sterling, "Looking Back at Lehman: An Empirical Analysis of the Financial Shock and the Effectiveness of Countermeasures."

My summary: John Taylor, John Cochrane, and Luigi Zingales say the Lehman Brothers catastrophe didn't cause the financial crisis of fall 2008 after all - instead, they say, it was Hank Paulsen saying there was a financial crisis, and that the government needed $750 billion to deal with it, and we can't tell you what we're going to use the money for. Their evidence is that LIBOR rates didn't move much after Lehman went under, spiking when Paulsen made his request. Sterling says - you dumb clucks, LIBOR data is drawn from surveys of how much banks say they charge each other for loans, not the observed rates on actual loans. In the days after the Lehman bankruptcy banks weren't lending to each other at all, hence LIBOR is meaningless. He reports the movements of the Bloomberg Financial Conditions Index, and lo and behold - well, just look at the graphs.

Keynes vs Hayek

Circulating in the attention economy of the "internets" is this Austrian appropriation of the hiphop vernacular.



Moralist tone of the Hayekian critique of excessive borrowing aside, I find it quite interesting how the liberatory tinge of Hayek's "I want to free the markets!" is made to contrast with Keynes' "I want to steer the market". In a sense, hiphop (an erstwhile element of alternative youth culture) and discourses of freedom are mobilized to support a particular economic ideology (and I am not using ideology in a merely pejorative sense). No doubt, underlying this freedom versus planning dichotomy is the ultimate normative bedrock of neoliberal creed: freedom of choice. Nevertheless in this particular context, it seems that our choices are truncated; they are limited to either steering the economy or freeing the economy. As if these two are our only choices. What about embedding the economy, or socialising the economy, or ecologising the economy? The implicit common denominator that brings Keynes and Hayek together is that both place their bets on economic growth as the ultimate aim of social evolution and that they are both blind to the systemic nature of class and ecological injustices of these creatively destructive but also destructively creative cycles of boom and bust.

Krugman on restoring the status quo ante

Paul Krugman draws up this schemata of the US financial system.


Traditionally banks lent to borrowers (diagonal line). Since the 1980s, much of the business of banking has been taken up by shadow banking (bottom line). The collapse of the shadow banking system has caused the Fed to create huge amounts of reserves and, since the banks won't lend them out, make loans directly to the public (right-most line).

Krugman asks:

Call me naive, but why does Fed policy seem to assume that the only way to repair credit markets is to return to the status quo ante, circa January 2007?... Are we still convinced that securitization is a far superior system to conventional banking, and if so why?

The answer, I think, is that banking is a particularly costly way of intermediating between savers and investors. It exists because of the problem of asymmetric information in credit markets. Securitization is a way of giving borrowers (almost) direct access to capital markets rather than going through the banking system, resulting in lower borrowing costs. The problem is that as practiced, securitization was not an alternative solution to the problems of asymmetric information but an end-around the banking system. The asymmetric information problem ended up biting us all in the butt. The optimal post-crisis arrangement, it would seem to me, is not to go back to traditional banking but to resolve the asymmetric information problems that exist in the shadow banking system through more regulation, higher capital requirements, etc.