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The End of the Beginning

October 9, 2008

“Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”—Winston Churchill, November 10, 1942

When Churchill made his famous statement following the allied victory at El Alamein in North Africa, he was warning the public not to be too optimistic, and to expect the war to continue for a long time. It now seems clear that the financial crisis will last a long time. I want to suggest here that we are at the “end of the beginning” of the financial crisis, about to enter a new phase. Unfortunately, this is not an optimistic statement, merely an assessment. The government is fast running out of policy options that bear any resemblance to “free market” policies. What remains is for the federal government to run everything. And this is what is gradually occurring. The challenge will then be for the government to undo all of its intervention as quickly as possible.

Consider (if you can bear it) the situation this week:

  • Banks have stopped dealing with each other, with the Fed serving as primary lender to banks.
  • Financial firms are not making loans.
  • Credit default swap (CDS) prices for financial firms remain at record levels. (Corresponding to the high CDS quotes, the debt of these firms is trading at very low prices.)
  • Commercial paper outstanding is falling and the bulk of issuance is at very short maturities.
  • California, unable to borrow in municipal markets, may ask to borrow $7 billion from the federal government. Massachusetts also faces borrowing difficulties, as presumably do other states.
  • AIG was granted an additional $37.8 billion to stave off default.
  • European governments are now facing similar situations, increasing insurance on bank accounts, rescuing financial institutions, and (in the case of Iceland) trying to stave off national bankruptcy..

You’ll notice that I didn’t even mention the stock market.

Two other news items in the last week make me think we have finally reached the end of the beginning.

First, the Federal Reserve has created a facility to buy 3-month commercial paper (short-term bonds issued by firms). The fed will essentially swap Treasury bills for commercial paper (CP), doing exactly what my colleague Arvind Krishnamurthy described in his blog entries (here and here). Firms issue commercial paper and the government buys it, effectively replacing the commercial paper with government bonds. Most importantly, this will prevent a major firm from going bankrupt simply because it cannot issue CP to pay off CP coming due. General Electric, for example, had $63 billion of commercial paper outstanding in June. As that paper comes due, GE must issue new paper (or sell assets) to pay it off. The government will have to do whatever is necessary to keep the CP market running.

Second, the Treasury is seriously considering taking ownership stakes in banks, which it is permitted to do under the bailout bill. The purpose will be to provide capital to weak institutions, and the Treasury will presumably then be in a position to urge these banks to resume lending.

The executive summary is this: the federal government is taking over US credit markets. We are no longer talking about technical hacks and tweaks such as lowering the discount rate, the Fed accepting risky collateral when lending to banks, or the Treasury buying mortgage-backed securities. We are talking about direct federal intervention, with the government buying and selling assets and taking ownership. What else is left? We have to hope that once the government has fully intervened, stabilized the situation, and can do no more, then capital markets will start working again.

There is an irony and a danger here. At this time, the government is the only agent in a position to intervene, but the government is also part of the problem. No private solution will emerge with the government hovering in the background, making decisions on the fly (will a particular institution be rescued or abandoned?) and essentially commandeering markets. This is not to criticize the Fed and the Treasury, but we must recognize that commitments of private capital will require clear ground rules. At the moment, with the situation fluid and constantly changing, only the government can act. Having acted, the government will then quickly need to stabilize the rules that enable and encourage private action.

[Update: Mitsubishi UFJ Financial Group has reached agreement to invest $9 billion in Morgan Stanley. In order for the deal to go through, US government officials had to assure Mitsubishi that their interest would be protected in the event of a future Morgan Stanley bailout. I’ll emphasize two points here: first, fear of government action almost prevented a deal, and second, the US government is now a contingent equity holder in Morgan Stanley. ]

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Categories: financial crisis
  1. Dave
    October 10, 2008 at 1:15 am

    You close with an anti-socialist sentence.

    As an academic, doesn’t it make sense to evaluate whether there may be reason that socialism could work ongoing, even with such fluidity and secrecy as Bush administration capitalist ideologues begrudgingly outdo FDR as the biggest socialists in U.S. history?

    Couldn’t it be said the U.S. has had a “juvenile” semisocialist economic system for decades, and that after a wild “adolescence” of unbridled corporate welfare it is now going into a more serious period of “early adulthood” socialism?

    Why hope our present fling with corporate communism will end up being relegislated back to “good old boy” finance? Doesn’t government running all financial institutions with the help of the fourth estate have any grounds for justification?

  2. Robert McDonald
    October 10, 2008 at 11:04 am

    Dave, thanks for the comment. My post was intended to make the point that we’ve now reached the end game in the crisis. And you’re right that I’m presuming that private action will be part of the solution. I think private money re-entering the market will be helpful and a sign of recovery.

    Rather than describe the financial system as capitalist or socialist, I personally find it more helpful to describe specifically how government should be involved. And I think that calls for a careful discussion.

    The government has of course been deeply involved in financial markets since the 1930s. At various times (including recently) it has effectively “owned” major financial institutions (e.g., Fannie and Freddie), been a major player in particular markets (mortgages, student loans, disaster insurance etc.), and regulated a large percentage of financial institutions. I think some of this involvement has been hurtful, some helpful.

    Government involvement going forward is certain to be more extensive than it has been. The difficult issue is how to be sure that this involvement is helpful. The one thing we *don’t* want to do (I suspect you agree) is provide a safety net while permitting beneficiaries of that net to take huge risks and reap huge rewards, sticking the rest of us with the losses. I’m not advocating that form of “good old boy” finance.

  3. Dirk
    October 16, 2008 at 12:13 pm

    I don’t believe we can reach the end of the beginning- rather, we will be doomed to repeat it- until two factors are understood.

    First, in a world of expanding ideas, expanding motility of capital, ideas, and opportunity, and expanding population, assuring adequate money supply to “grease the skids of commerce” will be a challenge. When there is unmet demand on a large scale, and unused capacity on a large scale, it should seem obvious that there is not enough money.

    Second, when the market (including home buyers) makes assumptions based on current interest rates, any government (Fed) policy that raises those rates must be seen as ultimately destructive if taken to excess. Our economy is a house of cards built on debt, and allowing the Fed to give the push that tumbles it about every 6-7 years (for example, 18 straight rate hikes from 1 to 6% between 2004 and 2006) and then come to the rescue with 1% rates again, seems foolish to me. There are many voices talking about the “too-low” 1% rates after 9/11, yet they don’t seem to want to decry them now. Why?

    And why I don’t hear more discussion about this issue- in my opinion, the real root cause of the current crises- is puzzling.

  4. Alice Maxwell
    February 10, 2009 at 9:55 pm

    Your publication is excellent and I enjoy your in depth analysis of current market problems but one important aspect of our national and ultimately world markets and commerce is missing. What about our relationship to trading partners in the Islamic world, none of which accept our markets in anything other than bonds, nor our banking instruments other than cash, the transfer of same?

    There appears to be myopia in our business world. In 2008, we witnessed the largest transfer of wealth from the western nations to Mideast sovereign states all because of oil which went way over Bin Laden’s demand for $100 a barrel for Allah’s great gift to his followers as his benchmark for calling off his war against the West! The price tag of that wealth transfer was said to be 700 billion cash dollars, all right out of our banks, particularly Citibank, the main oil transfer payments agent. Wasn’t that awesome cost the action that brought on our present crisis? Why are your business gurus overlooking that now?

    The time has come for Kellogg and its staff to investigate the world of Islamic finance. There you will find the answers to what is happening to the US and Europe. Just go to Google and try the search. You will be amazed at what you will find and the answers to the conundrums you are presently investigating.

    By the by, do you realize that all major international banks have whole departments now dedicated to Shariah law, right from the Koran, and even our treasury has a number of those experts on its staff. Perhaps you should write a piece on Mr. Kashkarrie, who doles out all these funds you are now musing about.

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