Delong: Ben And Hank Go To The Mortgage-asset Meltdown

Ben and Hank Go to the Financial Crisis J. Bradford DeLong Professor of Economics, U.C. Berkeley Research Associate, NBER [email protected] September 23, 2008 DRAFT If on the morning of Thursday September 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 $1000 Treasury bill investment—an annual interest rate of 0.4%. By contrast, if you had taken that $1000 and put it into a major bank in a three-month certificate of deposit—a CD—you would have been promised $14 in interest for the next three months: an annual interest rate of 5.6%. What does this big gap in interest rates mean? It means that even though the bank has promised to pay you back your CD principal plus $14 in interest in three months, people are not sure that the promise will be kept. 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 September 15? If the bank goes belly up in the next three months your investment is probably not a total loss: you will probably get threequarters of your money back, eventually. 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: 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 making investing in one rather than the other a fair

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bet: there are, the market thinks or thought last Thursday, 26 chances in 1000 that a typical bank will go belly-up in a thirteen-week period: one chance in five hundred each week, or the average bank goes belly-up every ten years. By contrast, the normal level of this T-bill to CD spread is much smaller: corresponding to one chance in 10000 that a typical bank will go belly-up each week, or the average bank is expected to go belly-up once every two hundred years. Now no bank can survive for more than a month or two when market risk is at such 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 lent. 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 bank-like institutions—unless the economic fever is broken and is broken soon. “Good riddance!” you might say. “Death to all the banks!! Those bankers—those smug overpaid suit-wearing bastards piously lecturing others on financial responsibility while they collect $$$$$$$$$$$ and wind up with fortunes in the $50 million or more range. Let their institutions die! Let them go bankrupt! Let them have to get minimumwage jobs working at the Rubbermaid Plant in Winchester, Virginia!” But that would not be wise. I could get behind the Winchester, Virginia part—it has pros and cons—but the “death of institutions” part is probably not what we want to do. It is not what we want to do because right now we are relying on the banks to cushion and manage a great economic migration. Eight million American workers who used to have jobs in construction or in high-end consumer services funded by free-spending yuppies using their homes as ATMS and taking out home equity loans on the appreciation of their residences have lost and are losing their jobs. They have to get other jobs in other sectors. The natural place for them to go is our export goods and services industries, and our import-competing manufacturing industries—those are expanding rapidly right now as the decline in the

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value of the dollar gains them market share from Americans and foreigners who now find it cheaper to buy American. But our exporters and our import-competing manufacturers need to borrow money to buy buildings and install machines if they are going to expand. If Wall Street freezes up, then they cannot borrow money—and the eight million American workers don’t successfully complete their migration across the economic desert to the waterhole. And then it snowballs. As their spending drops, still more people in other industries that had relied on their spending to create demand for the products they made lose their jobs. Et cetera. Up until two weeks ago I was hoping that we could get out of this without the unemployment rate ever going above seven percent (it’s 6.1 percent now) and with economists in the future having learned disputes in cinderblock-walled seminar rooms over whether 2007-2009 really was a recession or a not-quite-recession. Now I am hoping that we can get out of this without the unemployment rate going above eight percent, and without their being a big as opposed to small recession. That is the game that Federal Reserve Chair Ben Bernanke and Treasury Secretary Hank Paulson are playing right now: try to keep the banking system from freezing up; try to restore risk perceptions to normal levels; try to keep finance flowing—so that we have a peak level of only eight million unemployed in America next year, rather than fifteen million or more. Try to accomplish this while keeping feckless financiers who are responsible for the catastrophic failure of risk management that has gotten us into this from escaping with too large a share of their ill-gotten gains. And they have decided that they need help: permission to borrow an extra $700 billion on the faith and credit of the United States of America and then use that $700 billion to invest and buy mortgage securities. The hope is that the economy will recover and risk perceptions drop so fast that the government will make a profit on the deal—we did, after all, make a healthy profit in 1995-96 on the government’s interventions during the last Mexican peso crisis. The expectation is that we won’t see $100 billion of that $700 billion back. But that is a social investment worth making: if it does preserve the jobs of five million Americans during the next two bad years, then we have about $50,000 x 5,000,000 x 2 = $500 billion on the plus side. A 400% profit rate is a good deal.

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Treasury Secretary Paulson has a plan: give him the $700 billion and trust him. The big problem is that it is unlikely that he will still be Treasury Secretary on January 21, 2009, and there is a 48% chance that the next Treasury Secretary will be chosen by a man who thinks Sarah Palin is the American most qualified to be vice president. Trust is OK, but verification is better. Senator Chris Dodd, Chair of the Senate Banking Committee, has the responsibility for writing the bill to give Bernanke and Paulson the authority they believe that they need. It’s a hard problem—protection of the taxpayer’s interest vs. flexibility, punishing the feckless vs. effectiveness at restoring the flow of finance, rescuing deserving homeowners vs. rewarding those who used the housing boom to fund la dolce vita. It’s exciting to watch, if you are an economist.

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