Why the banks are hoarding cash

The BoE quarterly report has a table (reproduced below) of all the measures that have been taken by central banks world-wide to get banks lending again. The fact that, after all we are doing, they still are keeping all the cash they can get their hands on for themselves, shows that their difficulties are much worse than these solutions envisaged. I have written several times about the Credit Default Swap market, and here is a really insightful article (hat tip Eurointelligence) describing exaclty how the "CDS overhang" (or should that be hang-over?) is causing a sort of financial black hole into which any cash that comes into the orbit of a bank gets whooshed.

What the article makes clear is that taxpayer funds and guarantees -- worldwide amounting about £4.5 trillion -- do not cover the losses that banks are exposed to on their unregulated CDS dealings. A CDS is just an insurance contract: a bank agrees to pay out some stated amount if some specified  loan (bond)  goes bad. Banks, hedge funds and insurance companies found they could sell thisinsurance in large quatities -- far larger than the value of the loans being insured. In the casino on which the sun never set --- our modern financial markets --- there was a market in bets on other people's ability to pay, whether you had a stake in the game or not. There are $50 trillion of outstanding CDS contracts. It is fear of these liabilities that is making banks cash-hoarders.

But liabilities may well be capped below the $50 trillion number. When Lehman's was bankrupted, institutions that had insured Lehman bonds had to find cash to pay out on the insurance. CDS's are non-regulated, non-standardised, 'over the counter' (OTC) products and come with a wide variety of terms. According to the article, some of the CDS's required that the insured party deliver the underlying debt in order to get paid. This limits the size of the CDS payout overhang. Unsurprisingly, insurers have been asking for delivery of Lehman debt before paying out. It will be interesting to see if the price of bankrupted Lehman bonds starts to move up. 

 

 

 

Bjork the Autarch

Iceland's chill has led Bjork to tune in to her inner philanthrocapitalist. (Hat Tip CalendarGirl ). In this interview, Bjork describes her reaction to Iceland's economic woes and explains what she is actually doing to build a new economy based on green localist principles. Admirable for its pragmatism, is it a model for all of us?

Bjork

Bjork is looking to encourage MBA students, geeks and rural workers in Iceland to produce business plans that provide good incomes in the knowledge and eco-tourism economies in order to avoid building more  aluminium smelting plants --- that's what Iceland resorts to when it is in a fix, exploiting its huge hydro potential.

The dilemma faced by Iceland today---pay bills by inviting  ALCOA (The Aluminium Company of America, whose CEO was Donald Rumsfeld) to build more dirty business, or feel financially poorer but preserve the environment---is one we will all face soon. Is environmentalism a luxury?

Bjork wants to attack the problem by offering an alternative to ALCOA, a vision of "a new, independent, environmentally friendly Icelandic economy". She is building -- or thinking of building, I am not sure which -- an incubator for these new businesses. Sounds very attractive:

It's one big institution where everybody who has a good idea goes and they all work together and help each other and then companies start to come out of there. But it takes like eight years. For me, it's sort of like a record company. It's like an indie label in a way. It's grassroots, where all these people can come and feed off of each other and get support. Where if one person gets a good idea, the other five will help them..

But there are pieces of the idyl that are much less attractive:

  •  [We want to] "build this purely Icelandic thing up with Icelandic money, Icelandic companies."
  • "We should make companies here made of Icelanders, both working class and the brainpower, discover new things that stay in the country."
  • "Why not have the Icelandic people who are educated in high-tech and work already in those factories in the higher paid jobs, why not let them build little companies who are totally Icelandic with the knowledge they have? Then they get the money and it stays in the country."

There are hints of looking to use the incubator and environmentalism to keep the nasty world out in all these identitarian references. Why can't we have what David Hayes and Andrew Dobson have characterised as a Cosmopolitan Localism -- a localism and environmentalism that does not see the world as a threat, and that has the confidence to live its identities in the open? Iceland has just been slapped for its Viking raider hubris of the past 10 years. So a desire to retreat into autarchy is understandable. But it too should be resisted. It is just as much of a perversion as the raider mentality.

(Thanks to  verapalsdotir for the photo)

 

Darling and the Economics of Keynes

Tony Curzon Price (London, openDemocracy): Darling is going to announce that the budgetary prudence rules of his predecessor---to balance the budget over the cycle, unless the spending is on long term public good investment---don't apply. And he is right. But why does a rule that sounds so sensible have to be thrown out so soon after it was proposed?

BoE snapshot of crash

Tony Curzon Price (London, openDemocracy): The Bank of England's report on the state of finance has about 3 worrying graphs per page.

Here's just one example - the amount that UK banks will need tofind next year to pay back loans that are coming due.

 

Any wonder the banks are hoarding all that taxpayer investment they
are getting and not lending on? And if you were asked to invest in a
business that you knew had to stump up these sorts of sums next year,
would you worry that your investment was just going to stright into the
pocket of a creditor whose lending terms are tougher than your
ownership terms?

I'm all for the State being the bank of last resort, but I don't have any taste for the taxpayer being the dupe of last resort. Why don't we let these banks go under while putting in place an emergency financial system. I am glad to see that Walter Munchau has started to suggest this option.

BoE snapshot of crash

The Bank of England's report on the state of finance has about 3 worrying graphs per page.

Here's just one example - the amount that UK banks will need tofind next year to pay back loans that are coming due.

 

Any wonder the banks are hooarding all that taxpayer investment they are getting and not lending on? And if you were asked to invest in a business that you knew had to stump up these sorts of sums next year, would you worry that your investment was just going to stright into the pocket of a creditor whose lending terms are tougher than your ownership terms?

I'm all for the State being the bank of last resort, but I don't have any taste for the taxpayer being the dupe of last resort. Why don't we let these banks go under while putting in place an emergency financial system. I am glad to see that Walter Munchau has started to suggest this option.

Jarvis describes ... what oD tries to do

Here is Jeff Jarvis in the Guardian today:

"I want a page, a site, a something that is created, curated, edited and discussed. It will include articles. But it's also a blog that treats a topic as an ongoing and cumulative process of learning, digging, correcting, asking, answering. It's a wiki that keeps a snapshot of the latest knowledge and background. It's an aggregator that provides curated and annotated links to experts, coverage from elsewhere, a mix of opinion and source material. Finally, it's a discussion that doesn't just blather but tries to add value. It's collaborative and distributed and open but organised.

Think of it as being inside a beat reporter's head, while also sitting at a table with all the experts who inform that reporter. Everyone there can hear and answer questions asked from the rest of the room - and in front of them all are links to more and ever-better information.

It's not an article, a story, a section, a bureau, a paper, a show, a search engine. It's something new. What do we call it? The topic table? The beat bliki (ouch)? The news brain? I don't know. We'll know what to call it when we see it."

 

Jeff talks about the unsatisfactory atomisation that blogism has brought, and I have tried to express this in my piece on "The Blind Newsmaker". There is a sort of fallacy of decomposition that says that the web can recombine all the bits of journalism to create a satsifactory whole. Blogism does not produce the right atoms for that, because how you create determines what you create.

My view is that commissioning is the ingredient that has too often been dropped from the auto-publish web. In his article, Jeff is asking for coherence, for meaning, for a discursive arrival at partial understandings. The editorial conversations that lead to commissioning are at the heart of the creation of temorary moments of understanding.

openDemocracy's "open source model for news analysis"  is trying to work towards Jarvis' ideal newsroom.

 

Keynesian remedies and ignorance

The Sunday Telegraph publishes a letter from the rump monetarists---many familiar names from the economic crusades of the 1980's.
It is interesting to see how those old arguments play today.
Take this chestnut:
"It is misguided for the Government to believe that it knows how much specific sectors of the economy need to shrink and which will shrink "too rapidly" in a recession. Thus the Government cannot know how to use an expansion in expenditure that would not risk seriously misallocating resources."

This is true, of course, in some absolute sense of "know". However, as these very same economists have been quick to point out whenever it comes to governments dealing with clear errors of markets, for example with environment or anti-competition issues, the ideal does not make for a good benchmark. Just a market failure should be remedied if imperfect government can do better, so imperfect governments should be compared to actual markets, not imagined ones.
Look at the argument again: the financial system, which brought us massive over-investment in technology, in housing, in commodities, in conceptual art ... this is the process that should be trusted with avoiding "serious resource misallocations"?
The financial crisis has brought the government back into policy not so much because it has any answers, but because the market has demonstrated so unequivocally that it does not.

Krugman wins economics prize

While I am 100% with Yves Gingras that Economics should not have a Nobel, I am very pleased that Paul Krugman has been awarded the The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.

 PK has been a voice of sense on many issues, not least the Financial crisis - I have often linked to his NYT column from this blog. My personal favourite amongst his wide-ranging economics are his books and articles on Economic Geography. His "Self Organising Economy" has a particularly nice account of the forces that lead to the emergence of Edge Cities. Clear, simple and essential.

 

Time to rupt the banks

Will Hutton writes in his Observer column that "big public stakes in banks and offer guarantees to the interbank market [...] is a necessary condition for stabilisation [but] it is not sufficient."

While I agree with Will that we need to sort out the "black hole" of the Credit Default Swap insurance pyramid, I think that the time for recapitlaisation is now passed. Recapitalisation is not a necessary condition for stabilisation. The rapid creation of a new state lending bank is what is needed.

Recapitalisation might once have worked: financial pyramids are a confidence trick, and a state recapitalisation of the order of a few percentage points of GDP might have allowed a gradual, orderly wind-down of the massive liabilities. But the kind of confidence that would allow a gradual, muddle-through solution of the sort that happened in the Latin American debt crisis of the 1980s is simply no longer there. Barclays and RBS alone are the ultimate insurers against default of contracts worth more than the annual income of the UK. These are the sorts of contracts which, in an auction on Friday of Lehman Brother's assets, went for less than one tenth of their face value. The trouble with nationalisation and recapitalisation is that the liabilities do not disappear. When the slate is this heavy, you need bankruptcy to wipe it clean.

The financial sector is scrabbling aorund for whatever cash it can lay its hands on because every institution is likely to find itself in the position of having to pay out on insurance contracts with other parts of the financial sector that they know they cannot currently cover. The taxpayer with our capital injectionshave become the latest source of that cash, and we will see it disappear into the black hole of CDS liabilities.

The time for confidence tricks is passed. The banks are bankrupt.Time to stop  putting in good money after bad -- it simply will not help.

Save the real economy by rapidly creating a State bank that will lend directly to business, and let the finance system diappear into the black hole that it has dug for itself.

 

 

 

 

Plan-B

 

Plan 'B"

Tony Curzon Price

October 9th 2008

Face up to it: the Brown re-capitalisation plan may not work. The banks have relied to a massive extent on Credit Default Swaps, a sort of insurance on lending. They have given themselves false comfort, and in some cases very real cash-flow, on an insurance pyramid that will not hold-up under even modestly higher default rates. Liabilities under these insurance contracts are vast. One hedge fund was insuring 100 times its cash base before it went under. If the banks that we are now the proud part-owners of end up being heavily exposed to these liabilities--the total CDS market is measured around $50 Trillion, almost 1000 times more than the Brown rescue--we should just cut our losses and let the banks go under.

The problem is the protection of the real economy. The Federal Reserve has shown the way here, with its direct lending to companies, started 2 days ago. We should start a new state bank, recruit bankers and accountants from the City, and get them to work on lending to the real economy. At first, they will not have the time to distinguish good and bad loans. They will have to be lax but short-termist in their lending decisions. Their task will be to rapidly and efficiently become ``relationship bankers''--understanding the underlying businesses they are lending to and setting appropriate and gradually tougher lending terms. Once financial flows to the real economy are safe, the state bank should be broken into 10 identical pieces and with 9 sold to private investors who will operate in a new regulatory regime. The tenth should remain in state hands, as a benchmark bank, a way for the state to stay close to what is happening in the markets.

It is disturbing that the Brown re-cap was hatched by the Treasury, the Bank of England and top bankers. The trouble any regulator has is that the people who best understand the business and the crisis are the people you are trying to regulate. This is the basis of every regulatory capture. You cannot trust what the knowledgeable say to you. If the liabilities of the banks start to mount, let's make sure this plan B is ready to be deployed.

 


Why finance crisis will make growth fall

Nick Bloom has a good description of the most plausible transmission mechanism to medium term economic activity and growth over at VoxE:

So why is this banking collapse and rise in uncertainty likely to be so damaging for the economy? First, the lack of credit is strangling firm’s abilities to make investments, hire workers and start R&D projects. Since these typically take several months to initiate the full force of this will only be fully felt by the beginning of 2009. Second, for the lucky few firms with access to credit the heightened uncertainty will lead them to postpone making investment and hiring decisions. It is expensive to make a hiring or investment mistake, so if conditions are unpredictable the best course of action is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth. But this also has knock-on effects in depressing productivity growth. Most productivity growth comes from creative destruction – productive firms expanding and unproductive firms shrinking. Of course if every firm in the economy pauses this creative destruction temporarily freezes – productive firms do not grow and unproductive firms do not contract. This leads to a stalling productivity growth. 

I disagree strongly with Nick on his conclusion about the impact of change of policy towards an anti-market stance. The financial markets have imposed not only the huge direct costs of crisis on the economy, but also a huge opportunity cost in taking talent away from other honest, productive activities.

The essence of the de-leveraging crisis

Tony Curzon Price (openDemocracy, London):Paul Krugman has a simple model of the crisis that is a pretty useful tool to think about what is happening and what should be done immediately. It is not a model of why we got here, but a diagnostic tool for short term action.

First, Krugman's conclusions from the model are a) that taxpayers becoming shareholders in banks is a good next move and b) that international coordination of rescue plans is particularly important. Quoting him directly: 

First, it suggests that the core problem is capital, not liquidity - or at least that you can explain much of what's going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won't do the trick. Instead, what's needed is an injection of capital, which can't reverse the original shock, but can undo the financial multiplier effect of that shock.

Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home - we need you! 

Shorting neo-liberalism

I posted Gideon Rachman's FT column  on oD's The World link-watch page on diigo earlier today. Gideon writes:

Investment bankers, the shock- troops of the Reagan-Thatcher revolution, were allowed to bet their banks on this new market, because regulators and politicians believed so firmly in the magical and self- regulating qualities of the market.

The same process of intellectual overshoot happened with other signature ideas of the Reagan- Thatcher era: privatisation, scepticism about environmentalism and democracy promotion.

Well ... I think there is a kind of "democracy promotion" --- the kind openDemocracy stands for --- that is not neo-liberal and is in the wings, waiting for its open moment, as it were.

That apart, Gideon's judgement of ``overshoot'' is very welcome. I wrote asking him about the idea of "progress"  -- did he think that was oversold too? The pessimistic conclusion to his column, in which he saw just a batting back and forth between over-regulation and over-deregulation, suggested that he might be shorting progress too. Can we socially  learn from these crises?

 

 

Krugman explains de-leveraging

 

The essence of the de-leveraging crisis

Tony Curzon Price

October 7th 2008

Paul Krugman has a simple model of the crisis that is a pretty useful tool to think about what is happening and what should be done immediately. It is not a model of why we got here, but a diagnostic tool for short term action.

First, Krugman's conclusions from the model are a) that taxpayers becoming shareholders in banks is a good next move and b) that international coordination of rescue plans is particularly important. Quoting him directly:

 

 

First, it suggests that the core problem is capital, not liquidity - or at least that you can explain much of what's going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won't do the trick. Instead, what's needed is an injection of capital, which can't reverse the original shock, but can undo the financial multiplier effect of that shock.

 

Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home - we need you!

 

On the specifics of how to re-capitalise the banks, I have to agree 100% with the basic framework proposed by Willem Buiter.

The model makes it clear why we might want to re-capitalise the banks rather than allow the de-leveraging to run its course. Ordinary savers are quite right to be wanting to reduce their holdings of risky assets--they have understood that the investments they held were much less good quality than they previously thought. The price of houses, art works and all the bubble assets must still fall a great deal. But this adjustment, which is just a welcome return to reality, is creating massive knock-on effects as the ``Highly Leveraged Institutions'' of the financial sector have to reduce their lending because the price of the assets they were using as security for the lending is (rightly) falling. This forces the financial institutions to sell assets, making the problem worse. As Krugman points out, this is exactly the way that contagion spread from the Russian to the Asia to the Brazilian crisis in 1998.

Worryingly, the model leaves open the possibility of instability. In particular, if we --- we the ordinary savers --- become extremely unwilling to hold assets with any risk at all, then the model predicts that we spiral into a very nasty loop indeed. I do not think we are there yet, but the model underlines the importance of investor psychology at this point.

A financial system based on such highly leveraged institutions is not right. But we need to wean the system from that leverage slowly, giving the real economy time to adjust, while the logic of Krugman's de-leverage model is that this is being forced on banks at lightning speed. Re-capitalising the banks is a way of breaking the cycle of de-leveraging. Krugman's international conclusion comes form the fact that the banks all hold assets from all countries, so that asset price shocks ripple through the leverage multiplier much faster than would be suggested by the extent of movements of goods and services around the world. Krugman illustrates this with a nice graph.

So the way forward is becoming clear. Put capital into the banks following the Special Resolution Regime proposal of Buiter's to stabilise the system. Once the real economy has access to the credit it needs to operate, nationalise or hyper-regulate the banks and let the real economy slowly - over five years - reduce its dependence on bank credit.

The chart shows rest-of-world assets in the United States (red) and US assets abroad (blue) as a percentage of non-US GDP. What this shows is that when US asset prices fall, foreign financial firms feel the de-leveraging squeeze; and when foreign asset prices fall, so will US financial firms.

 

Krugman, Blinder & Co YouTube

Sounds like a firm of City lawyers -- Krugman, Blinder & Co. In fact, it is half the panel line-up on this excellent film of the Princeton Economics Department panel on the subprime crisis.(YouTube embedded below - the whole thing is about 1 hr, with the first 1/2 hour most informative, IMO).

Unfortunately, Blinder is mostly cut. Brunnermeier is fascinating on really detailed stuff---economists will never be short of clever fixes to regulation problems; Hong is really  interesting --- I want to post on his point about the psychology and sociology of systems prone to bubbles; Krugman --- well, if you've followed him in the NYT, you won't find any surprises here. 

The American Left's remedy for the meltdown

The progressive pressure group Campaign for America's Future - the left counterpart of the centrist Democratic Leadership Council - welcomed the House's rejection of the bailout and released three guidelines for further government action. Tony Curzon Price critiques the American Left's remedy for the current financial crisis. For more of Tony's analysis of the meltdown, go here. (editor's note

Invest In Main Street: On Main Street, jobs are disappearing, infrastructure is crumbling and local budgets are straining. A $200 billion economic rescue package for Main Street would generate clean American energy, extend unemployment benefits, aid states and localities to avoid debilitating cuts and modernize our crumbling infrastructure. 

More redistributive taxation in the US makes sense, as does generous, Danish-style unemployment insurance tied to re-training. Convincing America of this is a different matter. New Deal-style public works programs do not (yet) make sense. Most of the spare money for US investment is coming from Asia. Does it make sense to spend the savings of India and China on better roads in the US? No! Public works are useful in a depression, but we're not there and may never get to that point. It is not useful to confuse the finance bail-out with every other pet project one might have. 

Is there a ticking clock?

My note to the FT's Martin Wolf this morning, on reading his column, which argues (quoting Churchill Winston “The United States
invariably does the right thing, after having exhausted every other
alternative.”) that the time for a bail-out is now.

Dear Martin,

I enjoyed, as ever, your column on avoiding depression. I do wonder how much time we have (our political systems have) to negotiate the deal ... Paulson tried to tell us it needed to be done over 1 week-end; 10 days later it was not passed and the consequences are still mostly confined to the financial sector. What sets the ticking clock here? Presumably, the real economy's borrowing that comes up for renewal is the biggest deadline. And is that not temporarily extendable by central banks? Indeed, the various central bank facilities are presumably doing exactly that.

Given that decisions made in crisis are highly determinant of the shape of the eventual settlement, should we not be thinking about how to extend the window for negotiation rather than implementing a solution to the crisis?

Best wishes,

Tony

Keeping up with the economists

There's a huge amount of excellent and important commentary on the financial crisis. I have collected together the RSS feeds I'm using in 4 netvibes tabs that I am skimming through to keep abreast. You'll find feeds from Krugman, Roubini, Setser, DeLong, Thoma and many others who are commenting regularly on the crisis.

If you're not a netvibes user, go to the link here. You will see tabs across the top of the screen with Economics 1 to 4 - click those for the feeds. Click on a feed to have a quick read of what it contains, or do "shift+click" on a title to open the originating article.

The professional economics blogosphere, mainly under the influence of american academics, offers a pretty complete substitute for the analysis pages of the main newspapers. There are just a few exceptions - like the FT's own economics blogs (and especially Buiter's Mavrecon). An excellent European voice comes from VoxEU, a group blog of Euroconomists.

I hope you find these feeds useful, and drop me a line (tony dot curzonprice at opendemocracy dot net) if you've got some RSS feeds or sites that you think should be added to this list for crisis-watching.

The cost of mistrust

Tony Curzon Price (London, oD): Gamekeeper Hank Paulson has asked taxpayers to put up $700bn of risk capital to spend on his erstwhile and future colleagues on Wall Street. He has given permission to his previous employer, Goldman Sachs, to become a deposit-taking institution. (I am no financial adviser, but I would caution anyone to think twice before transferring their balances to Goldman Sachs today). Are the Democrats right to be resisting the blank cheque, or are they playing loose with the world economy?

The dilemma
is clear: crises require flexibility, rapid action and leadership; but the power of flexibility can be abused. Paulson, who rose to the top in the macho culture of "take no prisoners'' Wall Street is not the man the taxpayer should trust. Worse, the Bush administration's systematic capture by energy, military and religious interests does not suggest a culture that can be trusted with huge power.

Would you trust Paulson?

 

The price of mistrust

Tony Curzon Price

September 22nd 2008

Gamekeeper Hank Paulson has asked taxpayers to put up $700bn of risk capital to spend on his erstwhile and future colleagues on Wall Street. He has given permission to his previous employer, Goldman Sachs, to become a deposit-taking institution. (I am no financial adviser, but I would caution anyone to think twice before transferring their balances to Goldman Sachs today). Are the Democrats right to be resisting the blank cheque, or are they playing loose with the world economy?

The dilemma is clear: crises require flexibility, rapid action and leadership; but the power of flexibility can be abused. Paulson, who rose to the top in the macho culture of ``take no prisoners'' Wall Street is not the man the taxpayer should trust. Worse, the Bush administration's systematic capture by energy, military and religious interests does not suggest a culture that can be trusted with huge power.

Here, concretely , is the worry. The US taxpayer gives Paulson the risk capital. He spends it on buying up the assets that banks do not value--he buys them at a price that the banks find attractive. Once the bad assets out of the way, the banks no longer have to worry that their colleagues and counter-parties will go suddenly out of business and they can start to lend again. It is back to the good old days, except the taxpayer holds all the junk. Paulson has bailed his buddies; the Bush administration has rewarded its friends; bankers and lawyers learn to subvert the new regulation as they subverted the old. Wall Street--indeed world finance--can return to being a cosy club dedicated to personal enrichment.

This is why the Democrats now resist nodding through Paulson's plan. Paul Krugman summarises the problem on his New York Times Blog. The presidential politics make this particularly hard. It is a crisis and your leader asks for urgent help. As you start to raise objections, you can easily be turned into the cause of problems. Every time Nancy Pelosi says ''no'', markets will fall. There is a basic political Pavlovianism that will make the Democrats seem anti-economy. Obama's response to the plan--''it seems very big, but this is an emergency and I will not get in the way''--clearly recognises the danger. McCain's response--''Fine, but No New Taxes''--is clever: McCain protects the taxpayer, and no one thinks he would fail to support Wall Street.

The solution? The Democracts must put flexibility into the rescue package so that the next administration is not tied down to supporting a bad bail-out. Taxpayers should agree to put new money into banks in exchange not only for the toxic assets, but also for various options. Firstly, the option to turn those toxic assets into shares in the banks at the price before last Friday's announcement of a bail-out. This means that if world finance does recover past profitability, taxpayers will not have been the ultimate suckers, the ones who will always patiently take on the losses while others take on the gains. Second, taxpayers should require the option to monitor and cap all pay deals in the rescued institutions. As the Lehman case shows, profitability can go down while individuals still command astonishing rewards--not the rewards that an effectively nationalised industry should tolerate. Third, taxpayers should insist that the risk be borne by those who profited most from the leverage-bubble. Mark Thoma is very convincing that this should be done through a strong dose of progressive income tax.

The basic rule of finance is ''Who has the gold makes the rules''. When the banks have no capital, and the taxpayers are asked for gold, they need to remember that they make the rules. This is the moment to set the rules, not tomorrow, after a recapitalisation. There is a critical difference of a few months between today's crisis and the 1932 banking crisis that brought in the New Deal. Banks started failing in November '32, after the election. Roosevelt's plan was the important one. Today, unfortunately, three months make all the difference. It will be Paulson's rescue. The Democracts must avoid being cast as the destroyers of the economy, while standing firm as the rule-makers of last resort on behalf of that unlikely risk-capitalist, the taxpayer. Nouriel Roubini, long the Casandra of the this crisis, warns in his FT commentary that the crisis will spread to the real economy and to Europe's as well as the US's.

It is going to be hard, so now is not the moment to waste the hardship on a crony's solution.

 


tony curzon price 2008-09-22