Sunday, April 26, 2009

The Credit Crisis is a Choice

The credit crisis has moved beyond its initial stages. Virtually everyone has accepted this is a major global crisis. Virtually everyone has accepted that the core cause has been bad loans in which threaten to make the entire banking system insolvent.

However, now it is time to accept that the crisis is a matter of choice. The US government can effectively end a fair bit of the crisis immediately and can set us on the road towards healing. It can do this with two basic steps.

1) Making it clear that none of the major US money center banks, Well Fargo, Citigroup, Bank of America and JP Morgan; nor the two remaining major US investment banks Goldman Sach and Morgan Stanley; nor any of the major regional banks, US Bancorp, BB&T, etc. will be allowed to fail. None, no matter what.

2) Supplying credit and liquidity to the banks that is limited only by the bank’s tangible common equity, a measurement of strength that most banks get a good grade on.

My basic point for my more wonkish readers is that the US government can intermediate the entire global financial system if need be. That is the government, through the Fed, can print enough cash to keep lending going around the world. It can then “sterilize” these injections by issuing debt.

In short the government prints cash and then soaks it back up by issuing government bonds. The purpose of this round about action is to provide lending ability to banks. When the government prints money it does so by effectively loaning out newly created funds to the banks. Then the government borrows as much money as it loaned out, so the total amount of cash is unchanged.

The result is that the buyers of US government debt are effectively loaning their money to the banks who are in turn loaning it to consumers and businesses. However, the original savers are protected because the US government is effectively backing all of those loans.

This is not the way I would have preferred to solve the crisis. It involves the taxpayer taking on all the risk and effectively subsidizing the entire banking system. However, public outrage over direct government investment in the banks means that the good solutions are not available.

We should accept this and move on. We have the tools to end the crisis and we should use them.

12 comments:

Matt Young said...

To intermediate all the monetary dollar transactions, the Fed would need to trade along the term structure at all critical points. So, one would have a dollar term structure, defined mainly by the Fed's biggest customer, the U.S. government.

smalltownlawyer said...

I don't think I will be recommending the economics program at Chapel Hill to anyone anytime soon.

Ryan said...

Isn't the crisis already ending, without further intervention?

Karl Smith said...

Ryan -

I tend to think so. I get more optimistic by the day.

However, we are not out of the woods yet. There was a similar, though milder and shorter calm before Lehman collapsed.

Moreover, there are still some spreads which are disconcerting.

The essential point, however, is that we backstop against another major Lehman like event.

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