Getting to the Source of Systemic Risk

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Solving the US Banking Crisis

[Written for the Borsen-Kurier]

Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).

Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.

The catch? It will involve some short-term economic pain.

The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.

Here’s the plan, in two parts.

Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.

Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).

The sacrifice would begin when all imported goods immediately rise in price dramatically (an imported good that costs $1 may rise to $25). International trade flows would change as markets reach equilibrium. This would certainly cause some dislocation. But we’d skip the lasting pain of a sequel to the Great Depression because the main damage to the economy would be avoided. The money supply would not contract due to banks rational fear of collapsing during the financial crisis. Banks would be on a solid basis, and they could immediately begin lending (from savings accounts only; these would have to be set aside specifically for investment purposes, and would no longer be available on demand).

Sacrifices would continue as the US could no longer maintain a current account deficit without draining US gold reserves. The federal government would not be able to borrow billions or trillions to finance deficit spending. The depreciation of the dollar would mean foreign bond holders would immediately lose money, and large-scale selling of bonds would ensue. While it is unfortunate to break the trust of those who bought US bonds, it is simply unavoidable. The US has too much debt to pay it back. The US government will repudiate its debt, either simply and honestly, as in this plan, or covertly, through inflation.

Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.

The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.