Financial Crisis Act III: The Flailing Response
As we saw in Act I and Act II, the current financial crisis was enabled by government interference in the housing and mortgage markets, then initiated by Wall Street’s willful blindness to systematic risk in the MBS market. Now we are observing the government’s flailing response.
First they bail out Bear Stearns. Then they let Lehman go bankrupt. But AIG gets a lifeline. On to a $700B bailout intended to purchase toxic MBSs. And most recently forcing several probably healthy banks to absorb $250B in government investment. Along the way, there were a bunch of changes to FDIC regulations and a see-sawing stock market.
You might be asking yourself, what the heck is going on here? The reason for all the flailing is that the government is attempting to implement a command and control solution to an extremely distributed problem.
It all comes down to “liquidity”. Liquidity is a measure of the fungibility of an asset: how quickly you can turn it into something else. Cash is very liquid. Credit cards and checks are almost as good as cash. Investments in machinery, startups, and education are very illiquid.
Most people think liquidity is good. But it’s also bad. Illiquid assets tend to be the most productive. Cash just sits there. But a machine can make stuff. A startup can develop innovative products. A scientist can discover new things. So from this perspective, we actually want to allocate assets as much as possible to high productivity/low liquidity items.
If Company A keeps a lot of cash around while Company B invests in high productivity machinery, Company B will tend to out-compete Company A (at least over the short run where no negative Black Swans occur). Firms therefore demand the financial tools they need to be Company B. So the modern economy has evolved to support what we might call “just-in-time liquidity”. There’s no need for small firms to hoard cash because they tap a credit line. There’s no need for their local banks to keep as much cash as would be necessary to cover all these credit lines, because they can borrow from bigger banks. And so on for every cash supply line you can think of. But just-in-time liquidity relies on trust. Everyone has to believe that they can get cash when they need it.There must be enough total liquidity in the system to meet these needs.
The problem we have now is that some large financial institutions were holding a bunch MBSs that they thought were fairly liquid and worth X. Unfortunately, it turns out MBSs are no longer that liquid and are worth a fraction of X. A double liquidity whammy! So the banks that held them needed to sell more liquid assets so they could provide the total amount of liquidity their customers needed. But when almost everybody is selling, almost nobody is buying so these other assets became less liquid, which requires selling still more assets.
Meanwhile, the rest of the economy is quickly trying to adjust by conserving cash because they don’t believe they can get liquidity from financial institutions. Households are cutting down on purchases to. Small businesses are cutting staff. Manufacturers are slowing production. Raw material suppliers are reducing investments.
Taking toxic MBSs off the books and restoring liquidity at the top won’t solve the problem now. Everyone downstream is already adjusting and it will take time for people to begin trusting just-in-time liquidity again. It’s like removing a tumor after its metastasized. Sure it helps, but you’ve got to address all the low-level knock-on effects too. Unfortunately, the government is mostly set up to affect events top-down not bottom-up. They can buy assets in markets and strong arm big companies. But they can’t make everyone feel safe.
Add to the liquidity problem the need for real economic adjustments. At the end of the day, a bunch of people purchased homes they couldn’t really afford. A bunch of developers built homes for which there was actually no demand. Banks took risks that turned out badly for them. Other people made decisions assuming their homes were worth a certain amount and their homes are no longer worth that amount. No amount of wishful thinking or financial engineering will change these painful facts.
That’s why the government is flailing. First, they don’t really have the tools necessary to influence the distributed decisions of everyone in the economy. Second, with an election coming up, they would prefer that people not have to swallow all of the real economic pain now. But the system has gone chaotic and it’s hard to believe that the government can exercise any fine tuned control. I believe the system can heal itself and the government is almost as likely to make things worse as better. Best to just let things sort themselves out. However, I’m not terribly confident of these beliefs and am really glad I’m not the one in charge. The pressure to do something must be enormous.