The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.
Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.
First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.
Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.
Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.
Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.
Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.
This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.
Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.
The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.
Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.
The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.
At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.
The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.
Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.
The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.
Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.
Copyright Thomas I. Palley
Dear Sir — I implore you to increase the frequency of your blog entries for the duration of the financial crisis; please make them daily. It is a serious shortcoming of left-progressive economists in the U.S. that they lack media savvy and have no sense of the requirements of the media cycle. The reality at the moment is that such economists have the opportunity to shape the mainstream narrative regarding the financial crisis. The opportunity must be seized.
Mr. Prodi
When bond buyers refuse to buy subprime and alt-A bonds at any price, mark-to-market rules forces them to write their value down to zero. It happened with a money market fund today holding Lehman notes. It’s absurd. Whatever the default rate is, it won’t so high that those bonds are worthless. So your suggestion of relaxing the mark-to-market rule in the current crisis seems spot on. But does the Fed have the unilateral authority to do that? Does it violate international conventions? And would Bernanke’s Fed do it?
I’m struck also by the similarity of aggressive responses to moral hazard from right and left. The right wants punishment for failure. The left wants vengeance for prior success. Both want unrelenting specific justice at the expense of systemic risk.
As usual your art is excellent and as a radical economist I agree with it. I would only add certain references for the students interested. Without due reflexion I think for instance in the book by Turner (on the credit crunch and in English) the french books of Jorion and Arthus and the several good arts. in the Levy.org..
My best regards and congratulations for your work
José
[…] Thomas Palley […]
If one of the causes of the trouble is that financial institutions do not trust each other, relaxing the mark-to-market rules will only increase the distrust.
Rather than relaxing these rules, we need to get all derivatives traded on open exchanges with public pricing.
[…] Liquidation Trap On his blog, Thomas Palley warned of a liquidation trap that has falling asset prices causing financial distress, in turn compelling further asset sales and price declines. “The Fed must lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction? The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about ‘bail-outs.’ Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.” […]
We need to change the Mark to Market rule, to return control of the balance sheet to the managers and not to fire sale liquidators.
Unless serious discourse on non-bank regulation and the future tax burden distribution accompanies a publicly funded bailout, only the naive would expect political leverage not to be exercised.
Systemic risk should not be a trump card used to quell a discussion for which the public has now paid a fair price. Not looking behind the curtain with regulation and oversight is what got us here. So it seems disingenuous to dismiss what are effectively negotiation postures (by left and right) for a seat at the table so to speak. It is not imprudent, it is both just and necessary given the present regulatory environment.
[…] Thomas Palley has a fine post on the situation and some advice that goes against the prevailing wisdom: Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too. […]
What I don’t understand about your prescription of relaxing mark to market rules, is that for more than a year now we have been hearing about investment banks holding lots of assets in level 3, which is precisely not mark to market. And though I don’t have references on hand, my impression from what I’ve been watching for the last year is that companies have been moving assets into level 3 over the last year. I may not be correct about this, but my impression is that the Lehman situation comes about *despite* having assets in level 3. That is that even though they were marking to model their capital reserves became inadequate. Plenty of people have been calling for and end to mark to model for a long time (mish for example) but we haven’t seen Paulson or anybody else coming out and doing it. If there exist assets valued based on a model at this time, then your thesis that mark to market is causing the problem seems less clearly the primary cause. What if the models are showing that in an environment of falling house prices, and rising defaults, tranches of mortgage back securities are likely not to perform well, and if the poor performance indicated, also then implies poorly capitalized companies altogether.
Just exactly how long do these institutions get to assert what amounts to made up values for these assets under your proposal? A week? A month? A year?
Lets go with a year. Okay, so you get to pretend you have assets that you don’t for a year, are you going to start paying the mortgage payments to the MBS holders when the owners of the houses whose mortgages you control stop doing so? Well, okay, how much is that going to cost? And where are you going to get the money? borrow it? hmmm.
Okay, now what if it isn’t a year? What if it’s two years? Three years? What if when you revert to real accounting the problem starts all over again? the idea that people haven’t been rigging up the accounting to put a pretty face on things (lipstick on a pig I believe this situation has been called by some – calculated risk – for quite a while) simply flies in the face of truth. Your argument would be a lot stronger if there was a countervaling benefit to the people who are being asked to extend benefits to those who have been lying and cheating. You want to change the accounting rules? Ok, well, then we also ought to nationalize the institutiions requiring this little benefit, and begin an active and thorough investigation into the question of whether they knowingly violated the law. You want to change the accounting rules now, but it was entirely obvious that letting Fannie and Freddie run 80:1 capital ratios was going to turn into a disaster. Which is the real cause of the problem, and we all know it. It’s all well and good (sort of) to allow changes to manage a problem, but if those changes don’t address the problem, don’t actually do anything to fix the problem…
That thar’d be con-artists working for thieves
Thank you for a lucid, pragmatic description of where we are at.
I too am struck by the reaction of the right and left for moral consequences. I would suggest that the complexities of the system itself invites manipulation for personal gain at the expense of the system. The call for consequences to this behavior is a reaction to those in power acting in self interests, rather than the best interests of the system. Therein lies the paradox we currently face.
The belief that the pursuit of individual gain is of benefit to the system overall is the test we now face.
For many years the investment community wanted commercial banks to adopt mark-to-market accounting rules (Citibank currently uses MTM accounting). This was because investors generally did not believe that book-value bank assets bore any relation to their economic (i.e., discounted present) values. Now while it is true that bank managers must pay attention to their duration gap, they fought against FASB who wanted to impose MTM accounting on the commercial banking sector. So while the investment community seeks to blame mark-to-market accounting for the current crisis, it was they who wanted to use it to “discipline” commercial bank managers. I should also point out that “statutory accounting principles” (that state insurance regulators apply to property-casualty insurance companies), require insurers to adjust their “surplus” (i.e., net worth) each quarter by the amount of realized and unrealized capital gains or losses. While this introduces some volatility into an insurer’s capital base, it generally forces insurance managers to pursue a relatively conservative asset mix (say 70% bonds, 30%). So MTM accounting can have some “disciplinary” effects on financial managers. However, as Tom correctly points out, you cannot use mark-to-market accounting to value thinly/infrequently traded assets of possibly questionable asset quality (e.g., a commercial bank loan to an auto repair shop).
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[…] not really. I’m buggered if I know. But this post from Thomas Palley seemed as ‘on the money’ as any I’ve seen lately. […]