Arnold Kling  

The Cash Nexus

Me on KQED-FM Forum... House Concert Recorded...

Tyler Cowen writes,

There's a different way to think about the bailouts, namely that the U.S. government stands at the center of a giant nexus of money raising, most of all to finance the U.S. government budget deficit and keep the whole show up and running. The perception at least is that our country requires the dollar as a reserve currency, requires New York City as a major banking center with major banks, and requires fully credible governmental guarantees behind every Treasury auction and requires liquid financial markets more generally. Furthermore the international trade presence of the United States (supposedly) requires the federal government to strongly ally with major commercial interests, just as our government sides with Hollywood in trade and intellectual property disputes. To abandon banks is to send a broader message that we are in commercial and political decline and disarray, and that is hardly an acceptable way to proceed, at least not according to the standards of the real Washington consensus.

He continues,

This analysis bears on one of the main policy recommendations of Johnson and Kwak, namely to break up the big banks so they cannot soil Washington with such powerful lobbying and privileges. I believe this recommendation will not achieve its stated ends and that Washington would find another way to assemble privileged financial institutions - no matter what their exact form -- within its ruling coalition. Breaking up the large banks would be striking at symptoms rather than at root causes, namely the ongoing growth of political power and the reliance of that power upon an ongoing inflow of capital.

If you do wish to break or limit the power of the major banks, running a balanced budget is probably the most important step we could take. It would mean that our government no longer needs to worry so much about financing its activities.

I think that Tyler owes a footnote to Niall Ferguson, who sees this relationship between government debt and large banks as a historical phenomenon going way back. See also my macroeconomic lectures, number 8.

I think that our government became beholden to Wall Street for more than just financing its own debt. I think that Washington really came to believe that more home ownership is better, and that this goal requires cheap, lenient mortgage credit. If the government is focused solely on its own ability to raise money, then it is hard to explain why it would allow banks to treat AAA-rated mortgage securities as being as low risk as government debt.

Overall, I do think that Tyler is correct to point out that the relationship between government and banks was mutually beneficial. Many on the left, including Johnson and Kwak, describe the problem of our financial system as the banks overpowering the government, and this implies that government needs more power. Instead, my view is that concentrated power is bad both in banking and in government, and it is particularly bad when that power is used in combination.

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COMMENTS (6 to date)
Contemplationist writes:

Its interesting how simply framing the problem differently can yield different results.

Boonton writes:

How would standard monetary policy work in a world without important gov't debt? Today the Fed controls money supply by buying and selling 3 month Treasuries, expanding money by buying them and if it wants to contract money it can either sell them (3 month bills don't typically lose any money) or simply hold them to maturity and let the Treasury collect the cash from taxpayers and send it to the Fed.

Taking the Burkian stance that any long standing social institution probably has a logic to it that isn't immediately obvious, I wonder if large quantities of relatively safe gov't debt is needed for developed markets to function? Perhaps investors will be too risk adverse without the comfort of knowing if times really get rough they can always park their nest eggs in Treasuries and take a breather.

Boonton writes:

I think that Washington really came to believe that more home ownership is better, and that this goal requires cheap, lenient mortgage credit. If the government is focused solely on its own ability to raise money, then it is hard to explain why it would allow banks to treat AAA-rated mortgage securities as being as low risk as government debt.

Washington came to believe? No. Washington always liked home ownership which is why programs to encourage have been in place for over half a century! Why would it allow banks to treat the securities as AAA?

1. Gov't had no trouble raising funds in the bond markets (see, for example, our former vice President's declaration that 'deficits don't matter')

2. Like everyone else, ratings agencies were swooned by the claims of 'magic'. Through the magic of financial innovation all the risk in owning an individual mortgage could be eliminated by owning pieces of thousands of mortgages. This innovation gave everyone something they liked while taking nothing away from anyone. Conservatives could point to the 'market' doing a better job raising home ownership than gov't housing programs. Liberals trusted Wall Street to take care of itself so they could worry only about discrimination in loans (they never thought that Harvard MBAs entrusted with billions of dollars could fail as badly as a min. wage dishwasher confronted with a deal too good to be true by a slick talking mortgage broker). Investors who brought the securities got superior returns. Wall Street outfits collected nice fees for selling them.

Like any other bubble something positive was fed to just about everyone and for a while at least nothing bad happened, which seemed to validate the 'great new thing' thesis. If the gov't didn't have any debt would it have happened? Well look at it this way, if all the debt was paid off there would have been hundreds and trillions of more dollars seeking a home, why wouldn't they have found it in the inflating bubble?

3. The tyranny of the straight line- I spoke a bit bout this on the 'looting' thread. The easiest way to forecast is to just draw a straight line. Unfortunately history is not a straight line. The observation that was tossed around, for example, that real estate as a whole has never declined more than 5% was an example of straight line thinking. If that was true then having a diverse portfolio of mortgages should be fool proof, even if people got foreclosed on the high prices would ensure principle would be safe. I recall reading the rating agencies justifying their high grades to the securities based on the fact that over the known history of the securities, defaults were very low. But the known history was only a few years! It is very hard to not only see where the straight line is taking you but also to understand why it will never bring you there!

mark writes:

I liked this post a lot but I would add a slightly different perspective, which is why I have always supported the bailout: the government is essentially a 20% investor in the US economy (20% being the rough federal tax take out of GDP) and is also completely undiversified as to that investment. Unless it wants to sustain a permanent loss on its sole investment, it does not have the option to walk away from a further investment,when the economy hits a bump, in contrast with a hypothetical commercial investor would decide, if said investor did not believe the investment carried an adequate return. In other words, ignoring cynical accounts of its motives, a rational dispassionate government could not say, "I am going to decline to invest in bailing out my financial sector even though it will trigger a great depression,I think taxpayers would get a better return if I invested in Chinese infrastructure" as a commercial investor might.

Elvin writes:

Treasury debt is very important for our financial system. The demand for collateral is huge and because of the Basel Accords, demand for AAA securities is huge.

With the decline of the AAA corporate credit rating, the finacial system tried to invent ways of building low risk securities for collateral, money market funds, and capital requirements. Unfortunately, as I have seen, Wall Street takes a pile of A rated credit (say, the typical homeowner in the early 1990s) and structures it so that 85% of it is AAA. In my mind that means that the other 15% must be B or less rated. More unfortunately, we mistakenly thought the typical homeowner was an A rated credit in 2006 when he/she was probably more a BB credit.

fundamentalist writes:

"...this implies that government needs more power."

That's the way "progressives" think. But the only reason politicians exist is to sell their power to the highest bidder. Give them more power and they will have more power to sell.

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