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Sunday, Jul 5, 2009
Our economic system is indeed on the verge of a serious meltdown, but lawmakers should not grant Bernanke and Paulson the far-reaching powers they call for in their plan.
By Brad DeLong
Read more: Congress, Wall Street, Economy, Opinion, 2008 election
Sept. 25, 2008 | This is bad.
Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke are not yelling for help -- asking for permission to print up $700 billion of Treasury bonds, sell them, and use the cash to buy up mortgage-backed securities -- for no reason. Things are bad in the financial economy and always threatening to spill out over into the real economy, destroying jobs and boosting unemployment. But things could easily get much worse: That is what Bernanke and Paulson are trying to stop with their valid call for assistance and their needed, albeit badly flawed, three-page plan.
Today's announcement that lawmakers are close to an early agreement in principle on the plan is good news for the country. Let's hope it has some teeth.
But what is going on? Back up for a second into the abstractions of economic theory. If on the morning of Thursday, Sept. 18, 2008, you had set out to park your money in a three-month Treasury bill, you would have found that the interest you could get was ... zero. Well, not quite zero: You would get $1 in interest over three months on a $1,000 Treasury bill investment -- an annual interest rate of 0.4 percent. By contrast, if you had taken that $1,000 and put it into a major bank in a three-month bank certificate of deposit -- a CD -- you would have been promised $14 in interest at the end of three months: an annual interest rate of 5.6 percent.
Why this big spread in interest rates? What does it mean? It means that even though the bank has promised to pay you back your CD principal plus $14 in interest in three months, the CD is a higher-risk asset, because people are not sure that the bank will be around to keep its promise to pay them back with interest. (By contrast, people are reasonably sure that the United States government will not dry up, blow away and stop payment on its debts in the next three months.
What if you show up in three months to get your money and the bank is locked tight with the lights off -- as in fact happened to people who showed up at the London office of Lehman Brothers on the morning of Monday, Sept. 15? If the bank goes belly-up in the next three months your investment is probably not a total loss: You will probably get three-quarters of your money back, eventually, after being tortured by lawyers over a period of years. On the other hand, if the bank goes belly-up it is probably because other very bad financial things are happening and you really need your money right then. The $250 you will have lost will be as painful to you as a loss of $500 in normal times.
So interpret the $13 spread in the interest paid over the next three months on a CD vs. a T-bill as an indication that one investment is a much better bet. The market thinks the T-bill is a sure thing.
But there are -- the market thinks, or thought last Thursday -- 26 chances in 1,000 that a typical bank will go belly-up in a 13-week period: one chance in 500 each week, or the average bank goes belly-up every 10 years at last Thursday's levels of risk. And not just banks: Every financial institution that borrows short-term and invests in assets that have value for the long-term, whether it calls itself a commercial bank, an investment bank, a universal bank, a hedge fund or a multipurpose bank, is now in trouble because the market fears that lending to it is risky and so is forcing it to pay through the nose when it tries this week to keep borrowing the same amount of money that it had borrowed last week. The normal level of this T-bill-to-CD spread is much smaller: Up until August 2007 it corresponded to one chance in 10,000 that a typical bank would go belly-up each week, or that the average bank would be expected to go belly-up once every 200 years. The market thinks that the banks are way risky right now.
In large part because the market thinks banks and other financial institutions are way risky, they are. There is a self-fulfilling prophecy element here. No bank or other financial institution can survive for more than a month or two when market risk is at current levels. Banks borrow a lot of money. They lend out a lot of money at a slightly higher interest rate. They make their profits on volume -- on the amount of money borrowed and loaned. Most of their loans are long-term: Their terms don't change when market conditions change. Most of their borrowings are short-term: Their terms do change when market conditions change. The high level of market risk and its rapid run-up from normal levels only a year ago last August means death to all banks, and near-banks, and shadow-banks, and banklike institutions -- unless the economic fever is broken and is broken soon.
Next page: Should we just let all bankers rot in hell?
