Things We Really Meant to Blog About At The Time, But Are Just Now Getting Around To

"My rule of thumb for thinking about the global recession is that whenever you hear claims that some country has weathered it unusually well because of Favored Policy Initiative A, you ought to first ask yourself if it’s not really just an exchange rate issue."

So sayeth the wise Matt Yglesias! Quite awhile ago, actually. We'd really meant to say something about it at the time, but we're busy and important, and also we spent the first week of April clutching a can of Boddingtons on our couch.

But it's a pretty brilliant insight. We wish we'd thought of it. People tend to underestimate the impact of exchange rates on economic performance. And, because we like strong things in America, we're wedded to the concept of a strong dollar, which means we don't properly ken devaluation as a policy choice.

We should. A floating exchange rate would help Greece along quite nicely, just as a fairly valued RMB would ease our current-account deficit. More than that, it cuts through some of the Ron Paul insanity that's lately gripped the nation. A floating currency isn't bad. It's just flexible. These days, flexible isn't a bad thing.

Lessons In Public Relations From The Vampire Squid

If you haven't yet read up on the SEC filing against Goldman Sachs, visit Felix Salmon's blog. Brilliant stuff.

A shorter version for our regular readers: You may remember Goldman Sachs, star of popular public relations moments such as The Great Vampire Squid And You, We Really Didn't Need $18b In Government Handouts (But Please Don't Check), and Doing God's Work.

Yes, they're a likeable bunch over at Wall Street. The type of people you'd like to sit down and have a drink with, so long as they were paying, and you kept an eye on your wallet, and never under any circumstance allowed them to structure a synthetic collaterallized debt obligation for you.

In their filing, the SEC accuses Goldman Sachs of being very naughty boys indeed. And it all began in the halycon days of 2007:

Back then, two companies, IKB and ACA, hired Goldman Sachs to help structure a synthetic CDO. The details are all very complicated, but it's enough to understand that a synthetic CDO uses swaps to create credit exposure on mortgage-backed securities. By assuming a long position, IKB and ACA stood to earn money if the securities gained in value.

Goldman turned to Paulson & Co. Paulson assisted ACA Management in creating the CDO - selecting the underlying securities on which it was based. Trouble is, Paulson was assuming the short position – they were betting that the CDO would decline in value. Because of that involvement, they were able to cheat. In the words of the SEC, they "identified over 100 bonds . . . expected to experience credit events in the near future."

Goldman knew this. They knew Paulson was short mortgage securities and, according to the SEC, intentionally misled their clients into thinking he was a purchaser of the equity tranche.

It's absolutely mind-blowing. Goldman raked in $15 million in fees from the deal and IKB and ACA suffered huge losses. A big deal indeed.

In Which We Follow Up From Yesterday

Each happy marriage is alike
Each unhappy marriage is unhappy in its own way.
- Tolstoy, Anna Karenina
Yesterday, dear readers, we failed you. We went and wrote a long, charming, cutting, and utterly enlightening post about the too-big-to-fail banks, but completely forgot to explain a key point: Why makes these banks too-big-to-fail in the first place?

See, not everyone has bought into this particular bit of dogma. Quite a few smart and well-intentioned people have argued that the best thing to do is leave the banking sector to its dirty fate. Damn the torpedoes! Full speed ahead, and all that.

Here at the Strawman Blogger, we aren’t too fond of that plan. But don’t take our word for it. Instead, let’s have a serious talk about financial crisis, what it means for you, and why we probably don’t want to go and irresponsibly let banks crash down willy-nilly.

Financial Crises – A Case Study

Recessions can be wildly different. They’re a bit like bacteria – there’s one in every shape and form. So Volcker’s recession, brought on as the Federal Reserve crushed inflation with staggering interest rates, was structurally from the dotcom crash, which was a much more conventional asset bubble.

But financial crises are all a little alike. It starts with a liquidity mismatch between someone’s assets and their liabilities, moves to a funding gap, and eventually ends up as systemic contagion. Follow us? Don’t worry. We’ll get you there.

To understand the financial crisis of September 2008, it actually helps to visualize a classic bank run. A typical bank earns money in a simple way. It takes in money through the form of deposits and sends it out in the form of loans. The difference between what it pays on deposits and earns on loans is its profit spread.

Of course, that model poses a few problems for the bank. Most notably, its liabilities are very liquid – people can withdraw their deposits at any time. But its loans are highly illiquid, locked up for anywhere between five and thirty years. Generally, this isn’t a problem. Banks are always careful to keep enough cash on hand to meet the needs of their depositors. But if something changes – if something spooks depositors into withdrawing a lot of money at once – a funding gap appears. Banks can’t redeem their assets quickly enough to meet their liabilities. A bank fails.

And what if the bank failed in such a way that people start to doubt the stability of other banks? They’d respond pretty rationally, by attempting to withdraw their money from similar institutions, which only creates the same problem writ large. A crisis at a single bank becomes a crisis for all banks. A bank run.

Of course, we don’t have bank runs anymore. Largely, that’s down to the FDIC. If a bank fails, the FDIC insures their deposits. More than that, it winds down the bank in an orderly fashion, sell its deposits to another institution, and pays out any bad liabilities from the insurance fund. People no longer have any reasons to withdraw their money because they know their money is protected.

Flash Forward

So we’ve solved the problem of bank runs. Why the Great Recession?

Ah, but it’s a brilliant interesting story. It all started with the rise of the shadow banking system.

A shadow bank is an intermediary. It doesn’t take deposits like a traditional bank. Instead, it channels money from institutional investors to regular businesses – among them, large financial institutions. Big banks.

Now, shadow banks have a peculiar asset and liability mismatch. Each day, they raise a substantial amount of money through the repo market and associated other forms of short-term financing.

This money goes to fund their day-to-day operations. But while their funding is liquid, the investments of a shadow bank tend be highly illiquid – long-term positions in the securities market that are difficult to unwind quickly. Not unlike the deposit versus loan mismatch we detailed above.

When significant questions are raised about a shadow bank’s viability, short-term lenders and the repo market react. Funding becomes more expensive or dries up completely. Investors demand a haircut. If doubts are severe enough, it can affect a shadow bank's ability to continue as a going concern.

And what if investors have similar concerns about other institutions? In unison, they start to get antsy about the repo market. That’s largely what happened after Lehmann collapsed in September of 2008. TED and LIBOR rates shot through the roof, investors panicked, and market liquidity vanished. We remember those days. They weren’t terribly fun.

Further, the liquidity mismatch has systemic implications. A shadow bank can’t passively sit by as its core capital is eroded. Instead, it will attempt to sell its long-term securities position to offset its losses. But when the market is crowded with sellers, it’s forced to discount these assets further, which makes its capital ratios look even worse, which scares even more investors away. And we haven’t even started on mark-to-market rules. It’s all quite a mess.

And size matters. If a shadow bank is large enough, its asset positions can be huge – to the tune of billions and billions of dollars. When this happens, it depresses prices across the system as whole. A large enough institution can set off a panic on its own.

From Wall Street To You

But what does that mean to you? Everything. The trouble doesn’t stay in the shadow banking sector. Since the repeal of Glass-Steagal, the biggest banks in the country also have investment operations. Shadow banking and commercial banking are two sides of the same coin. Pinched between their inability to finance their operations and the pressures placed on their own investment banks, these companies aren’t able to perform their traditional functions.

A bank without liquidity can’t extend new loans. That means that consumer credit collapses, which in turn affects the real market. Auto lenders can’t sell inventory, homes sit unsold. And many businesses, small and large, depend on short-term credit to meet their daily needs. Businesses, too, can have asset-liability mismatches. Invoices take months to redeem; payroll is due every two weeks.

From a shadow bank to a loan to your very own paycheck. Too-big-to-fail matters.

What Is To Be Done

As we said yesterday, it would be quite nice to cut the banking sector down to size. We don’t need reasons for this. We’re powered by our own sense of smugness.

But that’s not enough. As smarter men have mentioned, many small shadow banks can still pose systemic risks. So we’ll need to regulate them better. In the end, we’ll need a resolution authority that looks a lot like the FDIC, with the power to insure transactions on the repo market and wind down failed institutions.

It also might help to re-instate the traditional division between investment and commercial banking. Like Hamlet and his mother, they just don’t belong together.

Cutting the world’s problems down to size. That’s how we roll.

In Which We Ridicule Too-Big-To-Fail

Meet the new boss
Same as the old boss
- The Who
Over the next few weeks, the Strawman Blogger is going to try to bury the hatchet when it comes to healthcare reform. The headlines have moved on, and the Strawman Blogger doesn't want to get left behind. Frankly, we need the page hits.

Instead, we're going to transition back into the world of finance. No more individual mandate in this blog; the SMB is all about leverage limits and the crisis in Greece. Get with the times, people.

To kick it all off, we're going to talk about the thing that's on everyone's mind: Too-big-to-fail. These are the bailout banks, the institutions large enough that, when the financial crisis rolled around, the government stepped in to keep them afloat. No one likes them very much, but they're here to stay.

So today we'll talk about the common solutions for the too-big-to-fail problem. We'll discuss their merits and we'll tell you what needs to be done.

Solutions you can use. That's what were about at the SMB.

The Contenders

There are quite a few suggestions to the too-big-too-fail problem, but they mostly fall into three discrete themes. Let's jump right in:

The first theme, as the old quote goes, is that too-big-too-fail is too big to exist. Got a big bank? Break 'em up. Either redraw the old line between investment banks and commercial deposit-takers or find another way to take them to pieces. But they gotta go.

We have sympathy for this position.

The second theme - championed by the likes of Paul Krugman - is that too big to fail isn't the problem. Or at least, not the problem worth focusing on. Krugman in particular has commented that a widespread series of small bank failures would pose the same risk to the financial system as the collapse of one or two large institutions. In his mind, it's the resolution powers of the FDIC that protect us from this risk. When a small bank collapses, the FDIC steps in to mop up the mess. Deposits are protected, assets are stripped and sold.

There is no similar protection for large institutions that have significant operations in the shadow banking sector, relying heavily on short-term borrowing. As these uninsured operations fall outside the purview of the FDIC, there is no mechanism that allows for an orderly collapse.

In this school of thought, something similar to the FDIC is needed for the shadow too-big-to-fail banks. If a capable resolution authority is able to dismantle big firms, protect their deposits, and impoverish their shareholders, the problem goes away. The too-big-to-fail fails.

Thirdly and lastly, there's the package of financial reforms preferred by the administration and congress. They don't do much more than nod in the direction of the too big to fail phenomena. Instead, they believe that a better regulatory structure - in particular, investing the Federal Reserve with oversight of important financial firms, bringing over-the-counter financial products like derivatives onto traded exchanges, and (maybe) creating a consumer protection board will prevent those nefarious and negligent practices that so nearly destroyed the world economy.

That's it. Better regulators? Consider us under-fucking-whelmed. In case you haven't noticed, our current crop of barely competent, functionally handicapped, practically illiterate regulators managed to miss the biggest financial crisis in the last eighty years until it was steamrollering over their fucking legs. It is unclear how they can be trusted to catch the next one.

Not that they would bother to look in the first place. Most regulators are too busy maneuvering for cushy exit jobs in the same companies they're supposed to be policing. Enforcing cuts in your future employer's leverage ratio is unlikely to endear you to Human Resources. It's called regulatory capture: See examples here and here. And here.

But honestly? All of that doesn't even matter. Here's the dirty little secret of the Great Recession: They didn't see it coming. There was no small army of brave regulators railroaded by the power of the Street. There was no corrupt cabal of crooked public servants, turning a blind eye to excess in return for their thirty pieces of silver. No one was outgunned or corrupt. They were just stupid. They drank the Kool-Aid, same as everyone else, and they thought the good times would last and last.

So the next time a financial crisis rolls around, new rules won't help. Caution is temporary. Stupidity is forever.

Our Estimable Opinion

So where does that leave us? Should we break up the big banks, create a resolution authority, or just cross our fingers and hope for the best?

Far be it for us to disagree with a Nobel Laureate, but we think Krugman has it wrong. Or at least, he's right in the wrong way. See, we weren't entirely fair to Congress in the description above. Chris Dodd's bill does include a resolution authority, and it forces big firms to pay into an insurance fund for that purpose. Congress has even bandied about the idea of strict leverage limits. The truth is muddled between our extremes. We lied to you. We're very sorry.

But we did it for a reason. There's a problem with resolving a big, failed firm. No one's ever done it before. Big firms fails during big crisis, and a big crisis is an unlikely time to grow a pair of testicles. We're unconvinced that, faced with a climate like that of September '08, the Federal Reserve would take a cool look around, let out a whistle, and take the axe to a bank like Citigroup. That requires a supreme level of cold badass. Cold badass is not what public servants are known for.

So we take a resolution authority with a grain of salt, for the same reasons we don't believe in better regulation. They both take someone smart, capable, and ballsy in the drivers seat. That combination doesn't come around too often.

Our Estimable Solutions

Break them up. So Krugman disagrees with us. Who cares? Cordon off investment banks from commercial deposit takers, impose strict leverage limits, impose capital ceilings, and then hell, regulate whatever's left if it makes you feel better.

We think this for two reasons. First, the collapse of many small firms can endanger the financial sector, but that's ok. The collapse of a broad number of small firms tends to happen because of a market failure, and market failures may just be unpreventable.

The failure of single-institutions, on the other hand, can be an isolated phenomenon. Long-Term Capital Management didn't fail because the broader economy stopped functioning. It just made a spectacularly ill-timed arbitrage and watched the world play hell with its spreads while its capital drained away. But because it was large enough, and interconnected enough, LCTM was saved anyway.

We don't actually mind saving banks during a market failure. We do mind having to clean up the mess of the rich kids during the not-so-bad times. Too-big-to-exist clears this up nicely.

And lastly, we'll level with you. Why do we really want to break up Wall Street and the big banks? Because we can. Because it's not clear that Wall Street isn't just full of rent-seekers who add nothing to productive society. Because it's not clear that Wall Street today is any more efficient at allocating capital than they were forty years ago. Because there are no real efficiencies of scale for a bank that holds ten percent of America's deposited assets, and a hell of a lot of drawbacks. Because together they drain talent from areas of American industry that could actually use it. Because. We. Bloody. Well. Can.

Maybe, as Krugman says, there will be market failures and global panics and financial catastrophes long after the big banks are dead and buried. Why not? There were before. But given a choice between a world of panics with big banks and panics without, we'll opt for the latter. We'd rather spend our money on people we like.

The Heritage Foundation Loves Healthcare Reform! The Heritage Foundation Hates Healthcare Reform!

There's nothing more blissfully entertaining than watching the ongoing contortions of the educated right as they attempt to rationalize why they loved healthcare back when it was Mitt Romney's conservative reform bill, but hate it now that it's Obama's, virtually identical, reform bill.

ThinkProgress has the goods.

– Heritage On Romney’s Individual Mandate: “Not an unreasonable position, and one that is clearly consistent with conservative values.” [Heritage, 1/28/06]

– Heritage On President Obama’s Individual Mandate: “Both unprecedented and unconstitutional.” [Heritage, 12/9/09]

– Heritage On Romney’s Insurance Exchange: An “innovative mechanism to promote real consumer choice.” [Heritage, 4/20/06]

– Heritage On President Obama’s Insurance Exchange: Creates a “de facto public option” by “grow[ing]” government control over healthcare.” [Heritage, 3/30/10]

– Heritage On Romney’s Medicaid Expansion: Reduced “the total cost to taxpayers” by taking people out of the “uncompensated care pool.” [Heritage, 1/28/06]

– Heritage On President Obama’s Medicaid Expansion: Expands a “broken entitlement program,” providing a “low-quality, poorly functioning program.” [Heritage, 3/30/10]

- Lee Fang

Poor Heritage Foundation's a-hurt! An about face like that is liable to give you whiplash.

But then, that's the trouble with this debate. Obama compromised so sharply on this bill that there's really no standing room to his right. You can criticize this bill for not being liberal enough. You could contend that it's not big enough. You could probably argue that it's not necessary, but inasmuch as that involves shackling yourself to the bloated monstrous landfill that is our current healthcare system, conservatives have been understandably reluctant to embrace this form of ritual suicide.

Which pretty much leaves lying like hell. Here's hoping no one notices.

Fun With The Budget #3

With a great sense of unease, we're going to quote a conservative.

This brings us no pleasure at all:

I appeared on Larry Kudlow’s show last night and we had a bit of a tussle about how much deficit reduction could be achieved by cutting federal salaries. Larry argued that a 5-10% pay cut for federal civilian employees like that imposed by Ireland could have a major impact on the federal budget deficit.

...

The total annual cost of all federal civilian pay and benefits can be estimated at about $260 billion. A 5% across the board pay cut would save no more than $13 billion , and in fact much less: remember, federal pay is unusually benefits-heavy. To put it another way: even if we fired every single federal civil servant and shuttered the entire non-defense federal government, three-fourths of the budget deficit would still be with us.

- David Frum

Well done, Frum! Well done, intelligent conservatism! For he makes an excellent point. As nice as it would be to balance the budget on the backs of these greedy bastards, it's not going to work.

But what would? The Big Three: Medicare, Social Security, and Defense. As Paul Krugman so delightfully puts it, it's best to think of the federal government as a huge insurance company with an army.

Fun With The Budget #2

As the old saying goes: Check it to wreck it.

Very often, the Strawman Blogger is treated to lengthy speeches about how easy it would be to bring our budget under control, if only we could cut out all of that nasty government waste.

And well we should! The Strawman Blogger is no fan of waste. But when we think about shrinking the government down to size, we like to think of the Parable of The Flatscreen.

The Parable of The Flatscreen

Once, a friend of the SMB was serving in the military. And yeah, it came to pass that his unit commander was sad. He was under budget for the year. And he was filled with great foreboding, for coming in under budget is an invitation to have your budget cut.

And there was a great wailing and gnashing of teeth! But then the unit commander alighted on an idea. Why not spend that money on a new TV for the break room? For all men need breaks, lest they decide that careerism is not all it's cracked up to be, and seeks well-remunerated jobs in the private security sector. The bastards.

And yeah, he did, and he became happy, and the men became happy. But some among them were full of wroth, for they understood that this was Manifest Government Waste.

The Lesson

When we hear stories like this, we like perform the following thought-exercise:

Cost of flatscreen TV: $3,000.
Men in unit: 50.
Average Salary: $35,000.
Total unit salary: $1,750,000.
Waste as percentage of salary costs: 0.17%.

Of course, none of these numbers are real (The story is, unfortunately. We've heard it fifteen bloody times). But it's a useful trick.

We hate waste because it's visible, and visible things make us angry. But lurking in the background is an ocean of government spending that doesn't bothered us at all. Hell. Who doesn't like paying soldiers?

Outside of this narrow parallel, it's best to remember that isolated, even shocking, incidents of waste are likely to a very small component of a larger system.

Fun With The Budget #1

We never tire of this, you know:



The blue bars in the graph above represents the popularity of various budget cuts. The red bar indicates how much of the budget those items take up.

Reduce the deficit! you say. Shrink the government! But not through Social Security. Or Medicare. Or defense. Daddy likes his aircraft carriers.

Pretty much the only thing polite society can agree on is that we should spend less money on those dirty cheating filthy foreigners. Total savings? Somewhat less than 1% of our budget.

In Which We Discuss The Vagaries Of Climate Modeling

There are many things the Strawman Blogger enjoys about the blogging life. The freedom. The wealth. The perfectly chilled Brut served to us daily by our Peruvian housemaid.

But arguing with various irritable conservatives isn't all fun. Especially when that conservative is our father.

Now, if the SMB has one talent, it's trading pointed verbal barbs with our eminent paterfamilias. But sometimes our conversations are just plain stressful. Yesterday's was a case in point:

"Look at all this rain," he said. "Global warming in action?"

"Well," we reply mildly, "It was a very warm winter."

"Yes," he shot back. "But wasn't it cold in DC?"

Next time, we will take a cab.

Now, the Strawman Blogger doesn't claim to be an expert on climate modeling¹. But we feel there's a lesson in this particular argument. So let's follow it to a hypothetical extreme. My father names a city that enjoyed an unusually cold winter. I name a city that had a very warm one. He names another, and I reply.

Given enough time, we'd exhaust all of America's largest municipalities. What then? Perhaps we'll go international. What was Paris like last February? Perhaps ocean currents hold the key - drop a few sensors in the Atlantic and we'll clear that up nicely. And so on and so forth.

Eventually, we'd have a more or less complete set of datapoints of temperature changes across the globe. Sound familiar? It's called a climate model. Scientists have been making them for quite awhile. And, in a not-unexpected victory for our world-view, they overwhelming support the concept of man-made global warming.

We've lost count of the number of times a cold snap has discredited the entire science of climate change. But no one has properly explained how a single data point is more relevant than half a century of research. So do us a favor! Stop trying. Or we really will have to call for a taxi.

¹Who the hell cares? Seriously. If you can't be an irreverent jackass with a poor grasp of actual issues, than frankly there's just no point in blogging at all.

The Idiocy Of The Common Man

If you are something
don't ask for nothing!
If you are nothing,
don't ask for something!
- Arcade Fire, Neighborhood
As regular readers of this blog will note, the SMB has always tried to be the voice of reason in the noisy debate about the American deficit.

We're very fond of this role. It's not terribly difficult, doesn't involve a great deal of strenous research, and allows us frequent use of the term "dangerous idiots" along with plenty of time to drink red wine.

So we found this survey interesting. Follow along as we quote Ryan Avent, quoting Matthew Yglesias, paraphrasing the survey in question:

In this economy, voters are wary of raising taxes, even if the revenue raised goes to something they deem important, like paying down the deficit. A majority (51 percent) say that even though the deficit is a big problem, we should not raise taxes to bring it down, while only 43 percent say that we might have to raise taxes to reduce the deficit. This rejection is even more acute among the least educated and lowest income voters, who are being disproportionately hurt by the recession and as such are even more strident in their rejection of a new tax to pay down the deficit.

And by an even wider 2:1 margin, voters reject cuts in Social Security, Medicare or defense spending to bring the deficit down (61 to 30 percent). With nearly three-quarters of the federal budget devoted to these items, exempting them from cuts leaves little room to make realistic progress on deficit reduction...

Nearly half of voters think the deficit can be reduced without real cost to entitlements, with 48 percent believing there is enough waste and inefficiency in government spending for the deficit to be reduced through spending cuts while keeping health care, Social Security, unemployment benefits and other services from being hurt.

SweetfancyfuckingMoses. Pull yourselves together, people. Even in a country with the level of taste necessary to embrace James Patterson, William Kristol, and the musical stylings of Wham!, this is embarrassing. You can raise taxes. You can cut entitlement programs. But you cannot tightly shut your eyes, click your heels together, and wish aloud for the Magical Government Waste Fairy to alight on the CBO Projections with the gift of $1.4 trillion dollars of government waste a year.

Grow. Up.