Deflation Alert

CPI down 0.1%. In the twelve months ending in March, prices declined 0.4% - the first yearly decline since 1955. How long will goldbugs continue to insist that ending up like Weimar Germany rather than USA circa 1933 is the real danger facing our economy?

Richard Cohen Is Not Very Bright

In an otherwise unremarkable column about the myriad failures of the Bush presidency, Richard Cohen throws us this brilliant line on foreign policy:

Whether you supported the war or opposed it, you have to concede that it should have ended years ago and, along with the invasion of Grenada, be a fit dissertation subject for a desperate PhD candidate and not, as it remains, a festering debacle.

Does Cohen really think that regime change in a small Caribbean island, and in a much larger, ethnically heterogeneous Middle Eastern state are comparable? Was this the "logic" he used for supporting the invasion of Iraq? Perhaps he should stick to what he knows - serving as a faithful stenographer for our elites - and leave the policy analysis to people who can actually think (the kind of people who understand cultural and historical factors matter when you're talking about toppling a government and occupying a nation indefinitely).

Frank Rich Indicts Finance's Takeover of Higher Education

As usual, Frank Rich captures the zeitgeist like no other in his column on Larry Summers. While most commentators have focused solely on any potential conflicts of interest Summers might have in his role as chief economic advisor after his comfy job at DE Shaw, Rich draws attention to how finance has effectively hijacked higher education. From Rich:

But perhaps I’ve become numb to the perennial and bipartisan revolving-door incestuousness of Washington and Wall Street. I was less shocked by the White House’s disclosure of Summers’s recent paydays than by a bit of reporting that appeared deep down in the Times follow-up article on that initial news. The reporter Louise Story wrote that Summers had done consulting work for another hedge fund, Taconic Capital Advisors, from 2004 to 2006, while still president of Harvard.

That the highly paid leader of arguably America’s most esteemed educational institution (disclosure: I went there) would simultaneously freelance as a hedge-fund guy might stand as a symbol for the values of our time. At the start of his stormy and short-lived presidency, Summers picked a fight with Cornel West for allegedly neglecting his professorial duties by taking on such extracurricular tasks as cutting a spoken-word CD. Yet Summers saw no conflict with moonlighting in the money racket while running the entire university. The students didn’t even get a CD for his efforts — and Harvard’s deflated endowment, now in a daunting liquidity crisis, didn’t exactly benefit either.

Summers’s dual portfolio in Cambridge has already led to one potential intermingling of private business and public policy in his new White House post. He tried — and, mercifully, failed — to install the co-founder of Taconic in the job of running the TARP bailouts. But again, Summers’s potential conflicts of interest seem less telling than the conflict of values that his Harvard double-résumé exemplifies.

In the bubble decade, making money as an end in itself boomed as a calling among students at elite universities like Harvard, siphoning off gifted undergraduates who might otherwise have been scientists, teachers, doctors, entrepreneurs, artists or inventors. The Harvard Crimson reported that in the class of 2007, 58 percent of the men and 43 percent of the women entering the work force took jobs in the finance and consulting industries. The figures were similar everywhere, from Duke to the University of Pennsylvania. Dan Rather, on his HDNet television program in December, reported that at Penn this was even true of “over half the students who graduated with engineering degrees — not a field commonly associated with Wall Street.”

I couldn't agree more. Maybe now we'll get a more rational allocation of our human capital. Instead of piling all of our best minds into conniving new ways to pile leverage on top of itself, we'll devote more attention to addressing the structural issues we face in energy and healthcare.

Defending Gaming the Geithner Plan

The inevitable gaming-the-PPIP-backlash backlash is on. After Joseph Stiglitz and Jeffrey Sachs lambasted Geithner's plan as a taxpayer rip-off, Noam Scheiber has taken to TNR with his oh-so-contrarian take that the PPIP being a scam isn't necessarily a bad thing. From TNR:

But is this really such a bad thing [if banks game the PPIP]? It sounds a lot like a good bank/bad bank model, in which we recapitalize Citibank to the tune of $925,000 and take the toxic asset off its books and stick it in another entity--a "bad bank"--created for that purpose. As I've said before, there may be moral objections to such an arrangement. (It is offensive that taxpayers have to bail Citibank out.) And the Geithner plan may not have enough money to recapitalize all the banks this way. But that's different from arguing that it can't work....

The only real difference, so far as I can tell, is who pays. Under Sachs's preferred approach, the bondholders and stockholders take most of the hit, while under his hypothetical gaming approach, the taxpayers do. Again, that's not fair. But being unfair doesn't doom something to fail. And I'd take an unfair success over a fair failure. (Though successful and fair would be ideal, and Sachs's proposal may get us close.)

What's a few trillion dollars between friends? But Scheiber ignores the very real possibility that the PPIP will not be enough - that bank losses will go well beyond the funding Geithner can manufacture with the FDIC and the Fed, and that the administration will have to go back to Congress. In that case, if the entire bailout process is perceived as an indefensible giveaway to Wall Street, then there is little hope of convincing Congress to pony up for more. If that happens we could be back where we were last September - financial panic as too-big-to-fail institutions fail.

Therefore, there is a premium on finding a policy that not only will work, but the public will see as being fair. Geithner seems to understand this, which is likely why he has resurrected the Paulson cash-for-trash plan with a few bells and whistles to distract the public (like any good magician, Geithner knows misdirection is key). But rather than trying to trick the public, wouldn't a much simpler plan that put insolvent banks into some form of receivership-on-steroids and restructured them make more sense? This would not only be good policy, but good politics as well; Axelrod and Emmanuel certainly understand that getting tough on Wall Street would be a popular position.

These are issues that Scheiber completely ignores. He seems to have completely bought the administration/banks' line that we must save the bankers to save the economy. But saving the banks does not mean saving the bankers who got us in this mess. Oops - I guess that makes me a radical populist.

Wells Fargo: Profitable Does Not Mean Solvent

One week you're announcing "record profits," the next analysts are saying you need $50 billion more in capital. As Matthew Yglesias notes:

This is why nothing you near from the financial sector about how all’s well should be taken too seriously. It’s true that given very bank-friendly monetary policy it’s easy for banks to run an operating profit. But most of these large banks are zombies—insolvent. They’re only able to run an operating profit because they’re not going out of business and being liquidated. And the reason they’re not being liquidated is government guarantees. It’s as if I had a profitable business selling cookies, except I didn’t actually have any cookies to sell and was just putting government-provided cookies in boxes, then bragging about how profitable my company is and how the government should stop hassling me about paying myself a bonus.

How long will it take for banks to earn their way out of insolvency? If the administration thinks the type of hands off approach Volcker took with probably insolvent banks in 1982 will work today, they're most likely wrong. As Krugman points out, any economic recovery probably won't be as steep today as it was then, creating a more difficult environment for lenders and borrowers. Please tell us this isn't really the plan.

Scraping the Bottom of the Barrel...

with Richard Cohen. Amidst the outcry over Larry Summers' $5 million sinecure at the hedge fund DE Shaw, Cohen takes to the Washington Post to voice his unsurprisingly contrarian dissent from the simmering populist rage. Cohen, after all, has made a career out of defending the prerogatives of the elite - from government officials who lied us into war, to the very journalists (such as himself) who failed to investigate these lies, to financial journalists who couldn't be bothered to ask questions about the housing bubble. But with the Summers-DE Shaw flap, Cohen takes his standard establishment hagiography to new Orwellian heights: we should not censure Summers for his ties to the financial industry, but, rather, lavish praise on him for passing up the riches of our new robber barons to re-enter public service. In other news from Robert Cohen: war is peace; freedom is slavery; ignorace is strength. From Cohen:

The recent headlines about Lawrence Summers had it all wrong. They announced with an implied breathlessness that he earned around $8 million last year -- much of it from the hedge fund D.E. Shaw. Here's what I would have written: "Man Takes More Than $7.9 Million Cut in Pay." Somewhere in the Diagnostic and Statistical Manual of Mental Disorders, the bible of shrinks, there should be an entry for "public servant." They are all, bless their hearts, a little nuts....

In our scandal-soaked culture, it is de rigueur to denigrate public officials and to search for the inevitable conflict of interest. But here are people, such as Summers, who have put aside wealth and lavish perks for government service. They have their reasons, sure, but whatever they are, we -- not they -- are the richer for it.

Unfortunately, Cohen is hardly alone in this establishment defense. Indeed, most of the establishment deign to indulge the masses with bouts of populist fury - AIG bonuses anyone - only to later lead the backlash against the backlash; informing the uneducated and unsophisticated masses why focusing on such details is trivial. The following discussion between Noam Scheiber of TNR and Megan McArdle of the Atlantic typifies this attitude.

This misses the point. For Scheiber, as long as there is no quid pro quo between Summers and DE Shaw, there is no scandal. Maybe. But does anyone believe that Summers will push for oversight or regulation of hedge funds/derivatives if he thinks a very lucrative post-government career at a hedge fund awaits him? The cognitive capture of our government, media, and academic elites by Wall Street is of vital importance. If our elites believe that what is good for Wall Street is good for America, then they will likely try to revive the status quo ante. Beyond whether this is even possible, it should be asked whether it is even desirable. Unfortunately, most establishment figures deem that a silly, unserious question.

Relaxation Tests

About those "stress" tests...turns out they're not so stressful. From the New York Times:

Regulators say all 19 banks undergoing the exams will pass them. Indeed, they say this is a test that a bank simply will not fail: if the examiners determine that a bank needs “exceptional assistance,” the government, that is, taxpayers, will provide it.

This is beyond farcical. If banks cannot fail the stress test by definition, then it is not a stress test. The notion that banks can both require "exceptional assistance" and "pass" their stress test is so absurd that it boggles the mind that anyone will fall for this. But, of course, some investors and talking heads (read: CNBC) will go bonkers when they see the headlines that the banks all passed, and they will pour into financials. Eventually, once writedowns continue to exceed puffed up earnings, even the slowest investors will realize that the banks are a bad bet. At that point, it will become apparent what an enormous waste of time this entire stress test exercise has been.

The saddest part is that the stress tests could have been the first step in a viable banking rescue. If Geithner had honestly assessed the banks' books and put hopelessly insolvent banks into receivership, there would be justified public confidence in the remaining banks. This is what FDR's banking holiday accomplished during the Great Depression. Unfortunately, Geithner seems to think that the minimal appearance of transparency and accountability is a good substitute for actual transparency and accountability. He is badly mistaken.

Pretending insolvent banks are healthy, pouring endless subsidies into them to prop zombie institutions up - it's all so Japanese. Weren't we supposed to have learned from their lost decade? And with each dollar siphoned off to Wall Street, Obama is throwing his presidency away...Maybe Obama and his political advisers will wake up and realize that flirting with economic stagnation is not a path to electoral success. We can only hope that they finally admit what an unmitigated disaster Geithner has been, and undo this mistake.

Sachs: PPIP Is A Scam

Columbia professor Jeffrey Sachs has joined the chorus of those proclaiming Geithner's PPIP a swindle. In the wake of the FT reporting that banks are considering bidding on each others assets, Sachs explains that while most commentators have worried about outsiders profiting at taxpayer expense, the potential for insiders gaming the system is even worse. From Sachs:

Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.

Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.

The earlier criticisms of the Geithner-Summers plan showed that even outside bidders generally have the incentive to bid far too much for the toxic assets, since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.

Are there any assurances that something like this would not happen? And is there anyone outside the administration willing to defend this plan?

Pinch Me, Thomas Friedman Is Making Sense

Even a broken clock is right twice a day. Or, when it comes to Thomas Friedman, even Captain Obvious writes a moderately insightful column every few weeks. In his latest column, Friedman makes a fairly persuasive case for preferring a carbon tax to cap-and-trade. The pluses:

• a carbon tax is transparent, and easy to understand
• cap-and-trade could be gamed by Wall Street, making a simple carbon tax preferable
• offsetting a carbon tax with a commensurate payroll tax cut is an easy way to make it revenue neutral, so opponents can't criticize it a regressive burden on working families; whereas the opacity of cap-and-trade is open to this line of political attack (this is the point of cap-and-trade: hide where the tax is coming from)

Of course, the Obama administration is planning on generating some $600 billion in revenue from selling carbon permits, so they probably wouldn't be too keen on a revenue neutral plan.

More from Friedman:

Since the opponents of cap-and-trade are going to pillory it as a tax anyway, why not go for the real thing — a simple, transparent, economy-wide carbon tax?

Representative John B. Larson, chairman of the House Democratic Caucus, has circulated a draft bill that would impose “a per-unit tax on the carbon-dioxide content of fossil fuels, beginning at a rate of $15 per metric ton of CO2 and increasing by $10 each year.” The bill sets a goal, rather than a cap, on emissions at 80 percent below 2005 levels by 2050, and if the goal for the first five years is not met, the tax automatically increases by an additional $5 per metric ton. The bill implements a fee on carbon-intensive imports, as well, to press China to follow suit. Larson would use most of the income to reduce people’s payroll taxes: We tax your carbon sins and un-tax your payroll wins.

People get that — and simplicity matters. Americans will be willing to pay a tax for their children to be less threatened, breathe cleaner air and live in a more sustainable world with a stronger America. They are much less likely to support a firm in London trading offsets from an electric bill in Boston with a derivatives firm in New York in order to help fund an aluminum smelter in Beijing, which is what cap-and-trade is all about. People won’t support what they can’t explain.

Don't worry: I'm sure the Tom Friedman we all know and despise will be back next week. He'll probably be telling us yet again why we must pay banks whatever they want if we're going to fix the economy.

Taleb: Why Can't Homeowners Mark Houses to Whatever They Want?

Nassim Taleb has been hammering this point home for weeks now, but it's worth repeating: increasing opacity in our financial markets and institutions will only delay recovery. Investors will, justifiably, not trust financial statements, and keep their money away. Taleb also asks a great question - why do we allow banks to not mark to market, but not homeowners. If homeowners had a fancy formula some quant invented that has little relation to reality and no one understands, would we allow them to mark their homes to whatever they want? Of course, there's a very simple explanation. Bankers contribute huge sums to politicians, and most normal citizens do not, so bankers get to live according to their own fantasy rules. The sense of entitlement manifested in bankers not having to acknowledge the full reality of this crisis, while everyone else suffers never fails to astonish.

Warren Drops A Bomb on Geithner

While she speaks in a mild-mannered tone, make no mistake: Elizabeth Warren TKOs Tim Geithner. In a measured tone, she lays out the three approaches to dealing with financial crises:

1. Liquidation, i.e. Chapter 11
2. Receivership. FDIC seizes the insolvent banks, separates the good and bad assets, recapitalizes the banks/gets bondholders to perform debt-for-equity swaps, and sell back the good bank to private investors
3. Subsidies. These can either be direct, in the form of capital infusions, or indirect, such as buying toxic assets at inflated prices.

Then Warren examines Treasury's policy of subsidization to date, before concluding

Treasury's overall approach seems based on the premise that the banking problem is temporary - and look, we all hope that's the case. If it is, more aggressive steps may never be needed. It is possible, however, that Treasury's approach fails to acknowledge the depth of the current crisis. The economy may not come roaring back. And the big profits that propped up the banks during the housing boom may not return. For some, that means it is necessary to consider alternate approaches.

Translation: this is not a liquidity crisis, and we're going to have to put insolvent banks into receivership. Hopefully Congress is paying attention.

Half of US Banks Bust?

Count Andy Beal among those skeptical about Geithner's PPIP. According to Beal

He says Treasury Secretary Timothy Geithner's new plan to guarantee loans to buyers of toxic assets won't lead to many sales because the problem isn't liquidity but price. They are not low enough. Half the country's banks--4,000 in all--would be bust, he says, if they marked their loans to what the loans would fetch in an auction. He says banks are fooling themselves by refusing to mark busted assets down.

"Banks are on a prayer mission that somehow prices will come back and they won't have to face reality," Beal says. And that reality, according to Beal, is going to get a lot worse. "Unemployment is going over 10%, commercial real estate hasn't even begun collapsing and corporate credit defaults are just getting started," he says. His prediction: depression, without bread lines this time, thanks to the government safety net, but with equal cost to society.

Whose judgment do you trust on whether this is a crisis of solvency or liquidity: a banker who noticed all the bad loans being made as this crisis developed, or a regulator who failed to diagnose the problem?

Greenspan's Wet Dream

Alan Greenspan must have a special place in his heart for Andy Beal. After all, if every banker ran their bank like Andy Beal ran his, then Alan Greenspan would not have had to repudiate his Ayn Rand-style libertarianism. From Forbes:

By September 2004 Beal Bank's assets had climbed to $7.7 billion. Then Beal stopped buying, letting his loans run off. By September 2007 assets had shriveled to $2.9 billion, one-fifth of which was cold cash. He was worried that consumers had taken on too much debt and money was being lent to companies for next to nothing. "Every deal done since 2004 is just stupid," Beal says.

He began by pulling back from home loans--even those guaranteed by Fannie Mae ( FNM - news - people ) and Freddie Mac ( FRE - news - people ). Beal thought the two quasi-government agencies were over-leveraged. When staffers mentioned their guarantees in deal presentations he would fire back that these guarantees were "worthless."

A banker whose perceived self-interest led him to abstain from the housing/credit bubble - I think Alan Greenspan might go all Andy Samberg on us. Unfortunately, Beal was the exception. Still, Beal's prescience shows that for those who cared to ask questions, the fallout from the housing bubble was fairly obvious. Hoocoodanode, indeed.

Boring is the New Sexy In Banking

It's back to the future in the banking world - that is, if our policymakers are serious about reforming our financial system. The myth that financial "innovation" cannot be stifled, lest the economy stagnate, has now been laid to rest. Financial "innovation" merely allowed bankers to take and spread risks they did not understand, perform regulatory arbitrage, and justify their exorbitant salaries. Paul Krugman and Simon Johnson both make the case that we should end the era of free-for-all casino capitalism, and move back to the type of more stable, boring banking system we had during the postwar period up till 1980. From Krugman:

Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some of which later turned out to have been based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative for those who ran it. Banking became boring, partly because bankers were so conservative about lending: Household debt, which had fallen sharply as a percentage of G.D.P. during the Depression and World War II, stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits.

As these changes took place, finance again became a high-paying career — spectacularly high-paying for those who built new financial empires. Indeed, soaring incomes in finance played a large role in creating America’s second Gilded Age....

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

Simon Johnson strikes a similar note, calling on policymakers to

make banks smaller, less powerful, and much more boring.

Using antitrust laws to break up too-big-to-fail banks into smaller parts, and re-instituting Glass Steagall and the division between commercial banking, which exists as a public utility, and investment banking, which takes on riskier enterprises underwriting securities, would be a good start. Unfortunately, Geithner and Summers seem too enamored with Wall Street to enact these reforms. We can only hope that more politicians can muster the common sense and historical humility that Senator Byron Dorgan did a decade ago, in condemning the repeal of Glass Steagall and deregulatory mania in general as an inevitable step towards a new crash.

If Someone Called Matt Lewis a Homophobe to His Face, Would He Notice?

Apparently not. But while the wingnuts at Townhall are easy fodder for lampooning, Lewis's incoherence speaks to the disintegration of the conservative movement. Social conservatives are rapidly finding that as the economy falls off a cliff, no one really cares whether gays are allowed to marry. Not even in Iowa. Far right crazies like Lewis have not made their peace with this reality yet. Meanwhile, foreign policy conservatives are busy claiming Obama's policies amount to a continuation of their own. And economic conservatives - Wall Street conservatives - have been completely discredited. Tax cuts for the rich and financial deregulation haven't been this out of vogue since the Kingfish was advocating his "Share Our Wealth" plan.

What's the future of the GOP? Who knows - but it's probably a Republican Party that acknowledges global warming, doesn't bash gays/use race as a wedge issue, and actually commits itself to running the welfare state responsibly. Something like David Cameron's Tories. It's going to take quite awhile for the GOP to modernize itself that much. Let's just hope they let the grownups govern without obstruction (and that the Democrats stop being so beholden to Wall Street too) while they work out their issues.