More Convergence of Views

Yesterday I highlighted an op-ed written by Desmond Lachman, a veteran of the IMF and Salomon Smith Barney (and currently at the American Enterprise Institute), comparing the United States and the current crisis to an emerging market crisis.

Saturday evening, Nicholas Brady, Secretary of the Treasury from the end of the Reagan administration through the entire Bush I administration, gave a speech at the Institute of International Finance – comparing the current crisis in the United States to an emerging market crisis, only in that case the banks were in the U.S. and the bad assets were in the emerging markets.

There are uncanny parallels between the situation we find ourselves in today and the one the Bush administration confronted a generation ago. . . . First of all there was a serious LDC [Least Developed Country] debt crisis. It’s easy to forget that in 1988 our banking system was in dire straits because the commercial banks held billions of dollars of loans in countries whose economic prospects had ground to a halt.

The solution, according to Brady, was identifying the fundamental problems and forcing all parties to recognize them.

Among the indisputable points we laid out were that new money commitments had dried up in the past 12 months and that many banks were negotiating private sales of LDC paper at steep discounts while maintaining their claim on the countries that the loans were still worth 100 cents on the dollar. There were more, and they were equally sobering. We used these irrefutable facts as a starting point in all subsequent meetings. Our rule was that no suggestions were permitted to be discussed if they didn’t accept the Truth Serum. They were off the table. Goodbye. Don’t waste time. . . . [W]e persuaded the international commercial banks—at first with great difficulty—to write down the stated value of the loans on their books to something close to market value in exchange for that lesser amount of host-country bonds backed by U.S. zero-coupon Treasuries.

Although Brady does not subscribe to the capture thesis that we outline in the Atlantic article, and is generally gentler on bankers than we are, his assessment of the financial industry is similar.

In broad strokes I would say that when I came to Wall Street in 1954, it was a profession, one that financed the building of this country’s industrial capacity and infrastructure. Year by year, however, the industry’s emphasis has moved away from that purpose and toward financial innovation for financial profit’s sake. . . . [T]he U.S. Department of Commerce figures show that from 1980 to 1982, the financial sector accounted for an average of 9.1 percent of U.S. total corporate profits. By 2005 to 2007 that three-year average had more than tripled, to 28.6 percent. . . .

First we should just come out and say it: the financial system that led us to the brink of disaster is broken.

And despite spending his career on Wall Street, and doing a stint as Treasury Secretary, he ultimately argues that banking should be more boring than it is today.

I believe that we need a simpler system centered on deposit-based banks. Under this approach, individual accounts in the depository banks would continue to be protected up to $250,000 and these banks would have access to the country’s central bank. These institutions would not be allowed to participate in markets involving inordinate leverage or equity transactions that would risk their deposit-protecting charter. In contrast to the current mode, when asked what their primary purpose is, the banks’ chief executives wouldn’t talk first about shareholder return. Instead they would stand up and say: “Our institution’s primary purpose is to repay the depositors’ money.” . . .

The highly innovative shadow banking system with its mantra of lower transaction costs, which would continue to introduce new concepts, would fund itself from the money markets and other sources but without federal guarantees and access to America’s central bank. Institutions that currently straddle the two funding markets would have to choose which type of business to pursue.

This reinforces a theme that Simon has been sounding recently: the divide is not between left and right, but between people who want to preserve the current financial system in its basic outlines (a little more regulation, a little more disclosure, exchanges for derivatives, etc.) and people who think it must be dramatically reshaped.

By James Kwak

17 thoughts on “More Convergence of Views


    Mr. Brady’s views seem to place him firmly in the first camp. That is, up until about September of 2008, we had depository banks and we had investment banks. (Okay, for accuracy, most depository banks offered “money market” accounts that were invested through investment banks).

    Then, in order to qualify for bailout money, the investment banks did some sort of conversion into regular banks.

    Have we so quickly forgotten the history of these financial shenanigans? Why is this blog post written as if the current abnormal situation was the status quo ante?

  2. The problem with the dichotomy you’ve presented is that those positions are not actually offering solutions or mechanical descriptions, they are offering narratives.

    Downsizing our financial system (let’s just go back to the 1970s) is a very quaint notion. So much of the discussion about downsizing the system is devoted to making the case that a smaller system is more desirable, which is a difficult enough point to make even while almost anything is more desirable than our current situation.

    I’m not a proponent of the current system by any measure; I’m just not sure how, practically and not philosophically speaking, we mechanically get from point A to any other point. I haven’t seen anyone who suggests that we downsize the system provide a detailed road map for getting there. (While we are returning to the 1970s, how do we address the actual outstanding contracts that have us in a precarious position, a population that doesn’t have much to export, and is unemployed and uncreditworthy?) Like Brady says in his speech – it’s complicated. But saying it’s complicated is not productive.

    We’ve made great use of the phrase “shadow banking system,” but in reality that phrase is an oxymoron. There is nothing systematic about the financial arrangements that our institutions carry with them but do not recognize.

    These financial arrangements are just a cancerous mass that is tangled throughout our vital organs. The surgeon is trying to explain why he can’t just cut the cancer out, while the very helpful relatives engage in vigorous debates about the patient’s behavior that contributed to the cancer and how the patient should live once the cancer is removed. Officials and ordinary citizens are just talking past each other, and we will continue to talk past each other until some very concrete ideas emerge as an alternative to the administration’s incremental and firm-specific approach.

    And the latter can’t happen without some genuine transparency on the administration’s part, which I think is worth whatever risk it presents at this point.

    Even as far as narratives go, I do not feel like taking either side of the dichotomy you’ve presented. I just feel like I’m trapped in a Joseph Heller novel in watching this all play out. The administration really needs to step away from its alliance with the banks and let the people have some specifics so they can move beyond storytelling. All the storytelling is doing right now is filling an intellectual void.

  3. It is profoundly interesting when Ronald Reagan’s Treasury Secretary has this to say:


    And his reasons for saying this: the financial community has moved its focus toward creating “financial innovation for financial profit’s sake.”

    I’m glad to see a conservative express the belief that capitalism works best when money is the means, not the end goal of the enterprise.

    I assume that Brady, a Reaganite, is not a liberal, big government guy. He’s a man who, I have to believe, once saw business as the solution to the problems caused by government.

    Now even a man like this takes issue with how the financial community has decided to run its business.

    The system is irrevocably broken and must be fixed.

    I personally like Brady’s idea that the financial market innovators – the ones who like to turn investment into a craps game – would do so without federal guarantees protecting them from failure. You play that game, you could win – AND you could lose. But you enter that high stakes game fully realizing that your failures will not propped up and supported by the government.

    A far cry from the reality we see today.

  4. It seems that various “narrow banking” proposals are making the rounds. Brady channels Krugman seeking to “make banking boring again”, while Kotlikoff and Leamer want to eliminate fractional reserve banking entirely…

    But no reforms at all will be politically feasible until the economy gets a lot worse than it is now. I fully expect this to happen as long as the current financial system is in place, forever booming and busting with with the full faith and credit of the U.S… But whether it happens in ten months or ten years, now that is the question.

  5. I think it is useful to discuss where we want to go even before we figure out how to get there. Especially when there is not yet a consensus on the former.

    That said… Perhaps I am naïve, but I do not think the general picture of “put the existing system into run-off mode” is all that complicated. First you need a commitment that any bail-out be contingent on ensuring it never happens again. That means no institution receives a penny of public funds without being placed in receivership and then run down: Shareholders get zero; boards and senior management get removed; creditors and counterparties… Well, those would be handled “ad hoc”. Maybe we really do need to make whole the creditors of the existing institutions to avoid global collapse. But at the same time, those institutions themselves would be eliminated, and the replacement institutions would explicitly not be guaranteed by the state, nor permitted to become “too big to fail”. “Never again” should be the mantra.

    This is really not very different from how the S&L crisis was handled in the 80s. But I bet you can think of a lot of things I am missing. What are they?

  6. Seems like Mr. Brady is calling the game for real.
    I have an increasing concern the fixit team unstated goal is to bandaid the existing banking system, allowing business as usual. I believe this is an unneccesary and incorrect goal which serves to signals government’s very substantial approval of their business practices. A signal not accepted by many and probably not supported by Congress?

    We see a lot of perceptive comments re cause, even some which almost suggest tar and feathers should be applied! However where is the desired result spelled out? If the main thing is to keep the main thing the main thing, then surely we need a finite statement of our nation’s financial services requirements. I doubt that our requirements include bean counters taking ‘fees’ for every contrived movement of paper. Now once we know where we are heading, voyage planning can be fixed.

    Many articles seem to interweave personal invective, multiple auxillary issues and rear-view mirror comments of the disaster. I suggest little of this is constructive re the main thing which (step 1) is to define the required unsinkable financial system. Step 2 is to have our elected governement adjust legislation to ensure no other financial shennanigns can be cloaked within a bank. This should take the President about a week?

    Questions such as:

    Fractional reserve(subject to dynamic government limits?)

    Deposit guarantees(requiring operation within approved banking process).

    Federal monitoring of all banks’s operations (key measures weekly?).

    Criminal charges for villains.

    Separation of merchant banking (no guarantees, free to fail)

    Securitisation to only be ‘with recourse’

    Limit to maximum size of enterprises.

    People who don’t want to play ball according to the rule set can take their bat and go home. No driving on our financial highways unless you are licenced and obey the road rules. Penalty is jail and seizing of ALL corporate and personal assets.

    I guess these points may take President Obama as much as another week?

    Given that we know what is the required outcome we now rero-fit existing banks. What is left (after the retro-fit) is subject to immediate bankruptcy challenge.

    The biggest problem plaguing us is uncertainty which feeds lack of confidence. Maybe the hiatus is caused by ‘bankers’ seeking to cover their own interests?

    Ok folks, how about we step up to the plate and address the main thing?

  7. I understand putting a company into run-off mode, but I do not understand what it means to put the entire financial system into run-off mode.

  8. What is not clear to me, at least so far, is how you factor in the global surplus/capital into the equation.

    There seems to be a lot of surplus floating around, and I suspect our malfunctioning economic system is based on theory (so far as there is any theory) that cannot in any stable fashion digest the surplus.

    Whatever solution we come up with must be able to allow for growing surplus along the two main dimensions: the surplus from slowly rising productivity in “developed” nations, and the jump in productivity when practice transfers from developed to undeveloped economies. This factor has to huge.

    The notions presented in the “Baseline Scenario” seem to be a critical aspect, but the growing global surplus is also a critical aspect. How to cover both?

  9. Are we going to provide a federal backstop on derivatives? (We can’t put them into a proper run-off because there were never any reserves here anyway.) What if those counterparties are not US entities? With what funds? Does anyone know how much this would cost? How would the cost change if we limited banks’ operations going forward? It is hard for me to have much faith in an elegant solution when I have no idea what we are dealing with here. We’ve dealt with one institution at a time successfully so far because it has postponed looking at the bigger picture. I’m not sure how that would count as progress. How can anyone say there is a simple solution when the problem can’t even be quantified without significant dispute?

    I doesn’t make a whole lot of sense to me that we would spend $trillions of taxpayer money on behalf of financial institutions and then tell them they are limited to, say, $100 billion of assets (pick whatever benchmark you want here). I’m sure other countries would love it if we governed that way, however.

  10. Among the notable points Brady makes…

    Debt is the immediate issue. We can argue about how we got here, whose fault it is, or the various immoralities and future repercussions with resolving debt in different ways. But debt is the immediate issue. The financial crisis began as a liquidity crisis, but now it is a debt crisis.

    There are three ways out of debt – paying if off, renegotiation (bankruptcy/restructuring), and inflation. Or some combination of the three.

    The question is whether we have reached the Event Horizon – the point of no return, where debt _cannot_ be paid off, as in the Latin American case. The Latin American crisis is a great example of why sovereign governments should be petrified to take on debt that is denominated in foreign currencies. They can’t declare bankruptcy, and they can’t print their way out.

    Without bankruptcy or inflation, the endgame for debt when the interest exceeds future income is serfdom. That is the Event Horizon.

  11. The evidence is now conclusive that as long as there is fuel (taxpayer funds available) there will be fire (bailouts.)

    If bailing out creditors leaves money/credit for more of the same, no pledge that “…replacement institutions would explicitly not be guaranteed by the state, nor permitted to become “too big to fail”…” will be credible (remember Fannie/Freddie?)

    Just as this bursting bubble is so much bigger than the S&L cisis and perhaps even the Great Depression, if the next one is enabled by current bailouts of sufficient size, it will be bigger still. Rinse, repeat, until bailouts become impossible.

    This cycle will repeat as long as financial institutions are allowed to legally create money out of thin air. That has been the common thread of all known financial crises. No tweaks have ever proven sufficient to overcome the extraordinary incentive to get fabulously wealthy with little to no risk.

    After so many many failed attempts – and disasters – it is unwise to believe that anything short of removing the rottenness at the core will work for long.

  12. Well said. As I recall, even 6 months ago fingering fractional reserve banking as the ultimate culprit would have been all but unthinkable (generations of banker-funded propaganda will do that.)

    While times are slowly changing, I agree that nothing short of a “full faith and credit” crisis, if that, will bring about fundamental reform. It’s tragic (since it’s avoidable,) but the historical evidence seems quite conclusive.

  13. Is there a debt crisis that doesn’t start as a liquidity crisis? Does it even matter?

    I think how we get out of this (bankruptcy or inflation and the attendant reforms) will determine whether or not we’ll get right back in.

  14. Mr Brady’s separation of the two kinds of banking sounds very sensible at first glance.

    But can banking and financing activities be segregated so that there is no point of contact between the two where the first set of boring banks rely on guarantees, explicit or implicit, from the more exciting shadow banking system?

    There surely will be a grey zone at the interface between the two -and if the shadow system continues to conduct business in a similarly reckless fashion to the status quo ante then the same systemic problems could arise yet again as troubled assets and obligations end up being intermingled amongst the two different kinds of banks.

    It’s one thing to say that the shadow banks will have no federal guarantees or safety nets but when things start to go wrong and markets seize up through illiquidity will the government really take a hard line and not come to the rescue. This is especially the case if the shadow banks have cross border risks with currency instability implications.

    It may come down to a choice between a Fed/Treasury clean up operation or a supra-national (IMF?) clean up operation.
    I doubt whether we would see too many hands go up if we asked who favors the latter

  15. I think that many of the comments here have hinted at a more fundamental issue – the problem is not how to regulate the financial system, but how to regulate human nature.
    There will always be the desire to make obscene profit at the expense (or, better yet, the perception of no expense) of others. We can write stacks of regulations a mile high and an industry will sprout up to find ways to undermine them. Two or three administrations down the road, a few campaign donations will prompt a few legislators to open a few loopholes, and here we go again.
    At the bottom of it all is that the banks, the Obama administration, and the public have one perfectly aligned self-interest in all this. EVERYONE wants things to go back to just the way they were. Bankers want their bonuses, officials want their “growth” and “economic prosperity”, and citizens want their credit, their 100% annual real-estate appreciation, and their big screen TV’s.
    Since the invention of money nobody has ever been able to regulate pure human self-interest out the system. And we never will.

  16. “Without bankruptcy or inflation, the endgame for debt when the interest exceeds future income is serfdom.”

    Make that rent, and you have the reality of the middle class for almost three decades. Inflation is eating savings. The difference between the interest rate at which banks can borrow taxpayer money, and the interest at which taxpayera can borrow from banks, is the subsidy that is meant to restore an insolvent bank industry to solvency. If present income barely exceeds rents, then serfdom already prevails. If serfdom is not your reality yet, then you might be one of the few who benefited, not one of the many who paid for, are paying for, and will be paying for our gentle investigation as to the subtle differences between illiquidity and insolvency.

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