What’s going on here? Let’s talk macroeconomic theory!

Money, as an abstraction, represents a sliver of the total productive ability of the economy. So, the value of the $20 bill in your pocket is ultimately determined by the productive ability of the economy divided by the total amount of money available at the moment.

Let’s assume that the productive capacity of the United States is stable. If North Korea manufactured a million $20 bills and handed them out to people on the street, the value of your twenty dollar bill would decrease. The term for this–when the growth in the supply of money exceeds the growth in the productive capacity of the economy–is inflation. If you have a wallet thick with $20 bills (you have lots of savings), inflation is working against you. If you owe money, inflation is great. Paying off the same debt (in dollar terms) requires less productive effort.

Assuming again the intrinsic productive capability of the economy is stable, let’s think through what would happen if trillions of dollars were suddenly evaporated–say by a gigantic retail bank failure obliterating checking accounts. Now, the $20 in your pocket represents a larger share of the economic output. That’s deflation. The winners and losers are opposite from inflation. The more savings you have, the better deflation is for you. If you’re indebted, you’re doomed.

Borrowing and saving are both critical for the health of the economy. Inflation discourages saving, deflation strongly discourages borrowing. Therefore, keeping a stable relationship between the productive output of the economy and the total money supply in the economy is the goal.

Here’s the rub: The productive capability of the economy is constantly in flux, and affected by an astonishing multitude of factors: New technologies, the availability of resources, monopolization of supplier companies for other companies, the weather, the overall enthusiasm of entrepreneurs, the number of work-capable people, the amount of labor each person can produce, the number of new ideas worth investing in, the state of infrastructure and on and on and on. Observing this, objectively, is beyond a difficult task; predicting the future productive state of the economy is even more difficult.

The old way to deal with this problem was to ignore it. Under the gold standard, the amount of money is fixed to be equal to the amount of gold in reserve. You could, at any time, exchange your crumpled dollar bill for a fixed amount of shiny metal. Therefore, the growth in amount of money was determined by how fast this one metal could be mined and refined from the earth. You can’t eat gold. You can’t make a home out of gold. And gold clothing is just tacky. The gold production rate is a poor correlate for the growth of the overall economy. The result–particularly during periods of rapid technological advancement in areas beyond metallurgy–were repeated cycles of catastrophic crashes. When an advancement dramatically increased the productive capacity of the economy, the money supply stayed relatively fixed–resulting in sharp, rapid deflation. The deflation stopped borrowing, stopping investment in new endeavors, crashing the economy over and over again. It was a terrible system, whose success depended almost entirely upon luck and faith in divine providence. Of course, Beck loves it.

Instead, we now attempt to measure as well as we can the state of the economy, and forecast how fast it is growing, and then ‘print’ enough new money (or, in theory subtract enough money) so that the ratio of the two stays roughly the same. While not perfect, it’s the far more rational way of dealing with the problem–harnessing mathematics, economic theory and plain-old empiric data.

Assessing and predicting the current and future state of the dollar-based economy is the primary mission of the Federal Reserve. Based on these predictions, the Federal Reserve adds (and theoretically subtracts) from the total money supply–in an attempt to keep the ratio of productive capability to money stable. Hence, the Beckian feverish repetition of, “…. how much money we’re printing at the Federal Reserve.” They (the Fed) are ‘printing’ money to replace that lost by catastrophic (entirely abstract) investments and reflect growth in the productive capability of the nation.

In it’s arsenal–to accomplish this herculean task–the Fed collects data on almost every aspect of the economy. Among all this data is a calculation of the inflation rate of the economy. A basket of goods (representing a cross section of productive output of the economy) is priced out in dollar terms on a regular basis. The rate of change in the price for the collection of goods is used as a measure of the inflation rate. This measure is probably the best sign of how well the Fed has done their matching job. High inflation rates mean too much money supply, low rates of inflation (or negative rates, reflecting deflation) represent too little money is being ‘printed’. Since the economic crisis that started in 2008, the rate of increase in this measure has been historically low–despite the historically large increases in the money supply by the Fed. Based on this measure, the Federal Reserve hasn’t printed enough money, to replace that lost by bankers in their spreadsheets.

There are reasons to be concerned about run away printing of dollars by the Fed–but it’s worth noting that the Fed is a quite conservative organization. At a baseline, the Federal Reserve tends to err on the side of too little growth in the money supply–fitting with the catering to the needs of the wealthy before the needs of the working that dominates US leadership generally. For now, there is no reason underlying the hysteria of the right-wing commentators.

It’s a pretty clever idea. Nobody has been able to make it work. Tumor cells seem to know the trick, and have potent means of telling the immune cells “back off, guys. We’re cool.”

Dendreon, focusing on prostate cancer (very common in older men), figured it out. In this most recent trial, they demonstrated efficacy of this new treatment to the satisfaction of the FDA. Since this therapeutic method is so new, the trial and standards were more stringent than for a more typical chemotherapy drug.

Not only is this really good news for prostate cancer patients, it’s also good news for the local economy. The intellectual property generated by the company should be applicable to other forms of cancer. Prepare for billions of dollars to start flowing into the state, as we are now the global leaders in a new way of tackling cancer.

Let’s look at the bios of the CEO and scientific leadership team:
Dr. Mitchell Gold: President and CEO.
“Dr. Gold is a former urologist at the University of Washington and currently serves on the boards of the University of Washington/Fred Hutchinson Cancer Research Center Prostate Cancer Institute and the Washington Biotechnology and Biomedical Association.”

Dr. Urdal: Chief Scientific Officer.
“Dr. Urdal received a B.S. and an M.S. in public health and a Ph.D. in biochemical oncology from the University of Washington.”

Huh. UW. You know, the highly productive public research University that brings in a billion dollars a year (or so) of out-of-state funding and is the largest employer in the city of Seattle. Also, the same University facing a 25-35% budget cut from the State and is planning to lay off 1000 people in a couple weeks, while jacking up tuition and cutting student rolls. After these cuts, Washington State will be 42nd out of 50 in State funding for higher education.

Who needs higher education? Taxes are baaad for the economy. The Republican superminority in State government tells us so. We already have a raging state economy. Raging! Sure, Boeing needed billions of dollars of state-funded life support during the boom years, has a commercial aviation division that can’t build aircraft and is facing cuts in orders to its most profitable aircraft, and a military division still reeling from the unexpected collapse of the Soviet Union twenty years ago. It’s not like China is going to figure out how to build aircraft! Never! And Microsoft’s monopoly is firmly entrenched, with no serious competitors on the horizon. Businesses are snapping up Vista and cannot wait for Windows 7. XP is long forgotten. Nobody wants that stuff. Nor is piracy of Microsoft products a serious problem, certainly not in the future markets of Brazil, Russia, India or China.

And our high tech economy has no need for well-trained employees. None at all. Sure, public universities are incredibly efficient at generating superbly trained and prepared staff for companies. But, why would Boing, Microsoft or other tech companies want to hire Washingtonians? If UW is gutted, all it’ll take is more H1B visas. With all the tax dollars we’ve saved, we can make our kids happy in the burger-flipping and car washing jobs that are the future.

Yes, our governor and democratic supermajority in the state legislature are faced with an impossible set of circumstances: a gaping budget hole caused by ill-advised earlier tax cuts and subsidies for failing industries, one of the world’s largest collections of idle wealth residing in the state, and an antiquated and ultra-regressive sales tax based revenue structure. What possible solution could be crafted from this raw material? Mysterious clues have been found in a yet-indecipherable code: aiseray axestay onay ichray. To help them in their quest of balancing the books, the governor has crafted a website where you can cut funding, and pick exactly which seed corn we should feast on now.

Should be a smashing success. Thanks, UW spinoff Dendreon, for showing us what we won’t miss at all.

From NOAA:

NOAA’s National Weather Service has issued a report that analyzes forecasting performance and public response during the second deadliest tornado outbreak in U.S. history. The report, Service Assessment of the Super Tuesday Tornado Outbreak of February 5-6, 2008, also addresses a key area of concern: why some people take cover while others ride out severe weather.
….
In reviewing the public response, the team found that two-thirds of the victims were in mobile homes, and 60 percent did not have access to safe shelter (i.e., a basement or storm cellar). The majority of the survivors interviewed for the assessment sought shelter in the best location available to them, but most of them also did not have access to a safe shelter. Some indicated they thought the threat was minimal because February is not within traditional tornado season. Several of those interviewed said they spent time seeking confirmation and went to a safe location only after they saw a tornado. Many people minimized the threat of personal risk through “optimism bias,” the belief that such bad things only happen to other people.

2. Willed ignorance in the face of growing danger, in service of greed.

From the Boston Globe:

The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized – and that bank failures were so infrequent – that there was no need to collect the premiums for a decade, according to banking officials and analysts.

Now with 25 banks having failed last year, 17 so far this year, and many more expected in the coming months, the FDIC has proposed large new premiums for banks at the very time when many can least afford to pay. The agency collected $3 billion in the fees last year and has proposed collecting up to $27 billion this year, prompting an outcry from some banks that say it will force them to raise consumer fees and curtail lending.

3. Manipulate and lie, to temporarily cover your ass.

From NakedCapitalism:

Readers may recall that during Lehman’s demise, a pitched battle was underway between some short sellers, epitomized by David Einhorn of Greenlight Capital. Einhorn raised questions about Lehman’s financial statements, specifically, inconsistencies and rosy looking valuations. The struggle became weirdly per[s]onalized, as Lehman sought to burnish the image of charmismatic CFO Erin Callen, as contrasted with the presumed to be evil company wrecking Einhorn. Of course, if the real performance (as opposed to what the reports said) was as bad as Einhorn’s line of inquiry suggested, it was management that had done the company-wrecking, but that level of detail is often lost on CNBC.

And one of the regular features of the Lehman versus its detractors affair was leaks to the media, leaks of a sort that even if the firm had done it in a way that it had plausible deniability, were clearly intended to reach outside parties, particularly the media.

Now let us turn to Citi. Recall what transpired, per the Wall Street Journal:

Citigroup Inc. was profitable in the first two months of 2009 and is having its best quarter in a year and a half, Chief Executive Vikram Pandit said in an internal memo aimed at boosting employee and investor confidence in his struggling bank.

Yves here. This is simply stunning. The Journal says up front a supposed internal memo was in fact intended to reassure investors.
….
Dunno about you, but this looks to me like a bald faced attempt to manipulate the stock price, and it certainly worked.

In the spirit of objectively tracking the downfall of the global economy, I’ve decided to begin a semi-regular post conglomerating data on the (non-)functioning of the financial system. If I’m going to panic, I want evidence backing it up.

Rather than focusing on the stock market (equity), like most daily coverage of this crisis, I’m going to focus on liquidity. The inability of companies, big and small, to borrow seems the most likely thing to impact people on a day-to-day basis. (For those of you seeking to retire shortly, well, this might not be the case. My apologies. You can read about the implosion of the stock market elsewhere.)

I’ve included the TED spread, US bond yields, Corporate bond yields, and a spread of the two I’ve crafted. If you know of an index that you think I should include here, please let me know. I fully admit I’m out of my depth here. Instruct me, and I’ll modify the post. A ton of data is available. Help me coalesce it into something coherent.

I’ve also included a subjective “beaker scale of economist panic” based on my sense of relative state of fear on experts writing about the crisis. As I get a set of objective data together, I plan to make this a calculated value–an SI-unit of doom.

		What this means to you
TED Spread	4.62 (up 0.384 or 9.064%) (Source: Bloomberg.)	Lower is better. The TED spread is a rough measure of how scared banks are to lend out their money, even to one another. The higher the TED spread, the harder it is for you or your employer get a line of credit. Lines of credit are crucial for almost all companies to function.
Treasury Yield Curve	Short-term: 3-month: Down -0.275 6-month: Down -0.159 Long-term: 2-year: Up 0.079 5-year: Up 0.083 10-year: Up 0.091 30-year: Up 0.029 (Source: New York Times.)	The lower the yield in the short term, the more frightened investors are of investing in anything beyond “risk-free” governmental treasury debt. The higher the long term debt yield, the more concerned investors are about the financial health of the US Government.
Corporate Bond Yield	(Source: New York Times.)	Higher is bad. The higher the yield, the more expensive it is for companies to borrow money to finance their operations.
Mattress Index: Spread of Corporate Bond yields to short term US government treasury yields	Investment Grade Corporate Bonds spread to 3-month and 6-month US treasury debt yield: 834.4 bp High Yield Corporate Bond spread to 3-month and 6-month US treasury Debt yield: 1981.4 bp	Higher is bad. The higher this ratio, the more risk adverse investors are. If money is flowing into “risk-free” short-term US government treasuries rather than companies, it will be increasingly difficult for the private sector to function.
Subjective Panic Level

Some worthwhile posts by actual economists, or people who know more about this than I:

Here’s a metaphor on the $700 billion dollar purchase of toxic debt from banks, with the option of bank takeovers by the government.

CalculatedRisk is freaking out even more than I am about the growing TED spread.

And it makes sense that the insurance company better be tightly regulated–forced to keep enough liquid assets around to pay out claims. If the insurance company failed to pay up, it would be a nightmare for everyone.

Credit Default Swaps (CDS) started out as insurance for bonds. For a percent or two of the face value of the bond per annum, you received a contract to pay the face value of a bond if the issuing company defaults. This is little different than life insurance, homeowners insurance or car insurance.

The trouble started in 2000, when the Commodity Futures Modernization Act explicitly banned the regulation of these contracts. Funny things started to happen. People took out CDS contracts on bonds they didn’t hold.

This would be like me insuring your car. Why on earth would I do that? Because if you get in an accident, I get paid. I’m gambling on your failure.

I could be even more clever and eliminate my risk entirely–at least on paper.

Let’s say the government similarly prevented regulation of the car insurance industry. I have $2,000 I want to invest. Your have a bond worth $20,000 at Washington Mutual

I have a good sense that WaMu is going to be in trouble in a bit. But, for now, WaMu is cheap to insure, so I buy a contract insuring your bond at $20,000. Costs me 1%, or $200, a year. It’s a long-term contract set at 10 years, so I’m locked in.

The mortgage market stumbles, and so does WaMu. Huzzah! Now you’re desperate for insurance, and since WaMu is in trouble insuring these bonds is going to cost more. Four percent a year, baby! I quickly sell you a contract: I’ll pay you $20,000 if WaMu defaults (the exact money I’d get if you wreck, since I still have a policy on you), and in the meantime, you’re paying me a whopping $800 a year.

This means I net out $600 a year, and it’s risk free for me. If WaMu defaults, I can pay you the $20,000 from the money I’ll get from my earlier contract, right?

Well, not exactly. What if the guy who sold me that earlier $20,000 policy is doing the same gambit, also leveraging a tiny bit of liquidity he has into a huge contract? And the person he bought a contract from is also doing the same game? And the person after? Horrible cycles can develop, where nobody in the chain really has the money needed to pay off the stack of contracts. All it takes to make these contracts bad is one irresponsible bettor at the bottom who didn’t bother hedging his promise to pay with a CDS of his own and doesn’t have the money to pay his promise.

It all devolves into something like this Beavis and Butthead episode:

This is precisely why the insurance market is tightly regulated. Nobody wants to be insured by the Great Cornholio. Since the credit default swap market wasn’t regulated, this sort of tangled mess grew into existence.

Well, how much money is tangled up in these sorts of “investments,” that did nothing of value, started no new companies, produced no new knowledge or techniques and are glorified get-rich-quick schemes worthy of a sitcom episode?

Sixty trillion dollars.

The entire bond market is about five trillion dollars. This is insane.

Lots of big numbers have been thrown around the past few weeks. But let’s put this one in perspective. The entire economic output of the entire planet was less than $60 trillion in 2007, at about $55 trillion.

2007 was the absolute peak of human endeavor, so far. More human beings were pressed into economic service in a more integrated global economy than ever before. Every single planetary resource was tapped at the maximum, every input stretched to the highest-ever limits. 2007 was the very best that human effort has ever accomplished. $55 trillion dollars of economic might is an astonishing amount of stuff, about $8000 worth for every human being on the planet. Real stuff. Not a line on an electronic spreadsheet or a number in a database. I’m talking surgeries, dental work, televisions, telephones, power lines, meals, airplanes and flights between cities, and on and on and on. This is the sum of our desperate fifty-five trillion dollar struggle to feed those who are hungry and unfed, to clothe those who are cold, to house those who are homeless.

It might be impossible for our government, even the entire collective force of governments worldwide, to untangle this mess of a fake parallel $60 trillion dollars, no matter how much tax money is thrown at it. The entire bailout so far–already unprecedented in scale and aggressiveness–has amounted to something around one trillion of hard-earned, real-world dollars–a drop in a bathtub of woe.

We can’t untangle this mess because so much was leveraged bullshit to start off with. These sorts of cyclical schemes aren’t investing in any true sense of the word. This wasn’t even gambling. It was a means of making numbers in spreadsheet go reliably upwards–increasingly detached from the real world, where making things grow and get better takes effort and risk. So much of the growth of the past few decades has been concentrated in this bullshit, these lies we’ve told ourselves while neglecting the real investments that could’ve made such gains a reality. It’s done.

We cannot resurrect that $60 trillion bullshit dollars tied up in bullshit CDS contracts without making our real $55 trillion dollar world go through a spasm of painful hyperinflation. In a world of $40 gallons of milk, $100 lunches on the Ave and $10,000 a month rents, we probably could conjure the illusory $60 trillion dollars into real existence.

Why should we?

It’s not as if we’re lacking in problems needing solutions–climate change, energy scarcity, almost every meaningful commodity priced at historical highs. A vast pool of money and a growing list of problems–why wasn’t the connection ever made? Why didn’t at least some of this wealth go toward solving these problems?

We could be riding high on American ingenuity. But we’re not.

Let’s say you and I start a company with the goal of replacing petroleum-based jet fuel. We engineer a bug that spits out something pretty close to kerosene. Excellent. Since we’re a company, we immediately patent the invention.

Now what? While we’ve just figured out a key step, our invention by itself cannot replace jet fuel. We need more pieces–the technology to refine our proto-fuel into something we could put into jets, the bioreactor technology to grow our bugs, a factory and its land, a distribution network, sales to airlines, and so on.

That’s a lot of pieces; we only own one right now. If we raised the money and assembled all of these to the point where we could actually sell an useful product, we’d be first. We don’t want to be first.

If we show it can be done, what would stop someone in China or India or somewhere else in the world from stealing all of this technology and competing with us? (Our present global economy isn’t exactly brimming with respect for intellectual property.) Without the cost of buying up patents—the costs of developing the technology—they’d easily outcompete us. By being first, we end up broke.

We’re better off selling our patent. We could sell this patent to someone who wants to turn it into a product—but they’d run into the same problem we would on that path.

The most likely buyer of our patent would be someone who desires our technology to never be turned into a product—someone who already makes jet fuel from petroleum. Patents, in our post-intellectual-property world, are more valuable as a defensive weapon. To a large extent, this is why all the wonderful scientific knowledge and technical ability pouring out of R&D labs fails to translate to something useful for humanity.

Think of all the companies that would benefit from a competitor to petroleum jet fuel: airlines, airplane manufacturers, hotels, restaurants, theaters… and if it benefits tourism, it benefits governments. For all of these, jet fuel is an economic complement.

The global economy suffers from antiquated complements. Energy sources. Commodities. The markets for many of these tricky complements are highly monopolized. Alternatives require the combination of many different technologies into a chain. By buying up one piece of the chain, the dominant company can prevent the competition from existing.

Broad swaths of the global economy would benefit from the cracking of these monopolized complements–just not the people who would have to be first in actually developing these alternative technologies. So the chains don’t get built. How do we get around this market failure?

I have a crazy idea: Since we’re rapidly socializing our economy–at least the financial industry–we should consider starting a new GSE, the Complement Cooperative.

The co-op would produce financial entities whose goal is to assemble these chains–”alternative to gasoline” or “alternative to jet fuel”–and give the entire chain away. Just like anyone can download Linux and install it for free, anyone could take the technologies in the chain and start a company–secure in the knowledge that someone has already shown that the chain works.

These Complement Co-op funds would take their endowments and contract out to labs to develop the key missing technologies or buy up patents as they enter the market. Throw in some talented patent lawyers, rooting around for prior art to destroy blocking patents. If we want to be really aggressive, the Complement Co-op could be given the right to use eminent domain to forcibly buy blocking patents–paying fair market value for the intellectual property–to promote the public good of new competition.

Combine a government-sponsored Complement Cooperative with a lending agency promoting the formation of new companies based on these given-away technologies, and you have a monopoly-crushing machine.

If the co-op’s entities are giving away the technology, how will they be kept solvent? By raising money from the industries that would benefit from the new technology chain.

In the above jet fuel list of potential beneficiaries, you’d hit them all up. The returns would come not from licensing fees, but from reduced costs on key inputs for their industries. Sovereign funds of governments would be delighted to invest, if the new product could help their economy or serve as a weapon against commodity-based rival nations.

This isn’t “risky.” If you have a sense of the likelihood of success of a given fund–how big are the technological hurdles?–as well as the potential reduction in costs–by breaking up a monopolized commodity market–you could calculate a probable return on investment for these sorts of financial instruments.

It’s a crazy idea, but less crazy than the farce that was our financial industry–the insane financial derivatives that crashed the market this time around. We have to adjust how we think of intellectual property. New inventions are still of use. We need to just help the market feel the value again. Something like the Complement Co-op would do it.

We need to start a new engine behind our economy. One hundred billion dollars–one tenth what we’re contemplating, about on order of what we paid for the tattered remains of AIG–would be more than enough to get something like the Complement Co-op started. We should do it.

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace….

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

The Wall Street Journal is right about one thing: the massive deleveraging of the whole global financial system is at the core of our present crisis.

What is leveraging? Investing with borrowed money.

When you’ve gotten those “Low Introductory Rate!” credit card offers, maybe you’ve been tempted to get the card, max out the cash advance, take that money and put it somewhere safe. Say the card has a 3% interest rate. You put the money in a 5% a year high-yield savings account. When the credit card rate is about to jump up, you take the money out of the savings account, pay off the card and pocket the difference. That’s leveraging.

If you’re mid-scheme, and the card’s rate unexpectedly jumped, you’d be doomed. Particularly if those low rate card offers are much harder to find. That’s deleveraging.

Our bailout of incompetence in the financial industry (otherwise known at the overcompensated kids who cheated off you in science and math classes) so far has three big parts:
1. Stop short selling of only certain favored stocks.

2. Buy up “toxic” debt, like the impossible to value mortgage-backed securities, at something like 40-cents to a dollar. We might be getting a good deal, or we might get hosed. Nobody, and I mean nobody, knows which is the case. You can shiver now.

3. Throw up to $50 billion of taxpayer dollars into Money Market funds, hoping to shore them up.

Last week, I wrote about a Money Market fund breaking the buck.

While there are many kinds of Money Market funds, the ones suffering the most (so far) lent money to the very oldest of investment banks. These were viewed as “safe” investments, due to the age and “respectability” of banks like Lehman Brothers.

Well, what will our fifty billion dollars be covering? Leveraged investment schemes, of course! What follows is a grossly simplified scheme of the sort of leveraged investment strategy Lehman Brothers, Bear Stearns and the ilk did with borrowed money from a pool declared to be super safe. In truth, many times the actual places this borrowed money went were more hideous, more dark and less responsible.

The favored investors come to an investment bank, or hedge fund, and ask you to take their million dollars and make it big, with minimal risk. The investment bank uses their good credit to borrow money from clueless investors at a low rate–from investments made into Money Market funds. These funds pay low interest rates to the investors, because they are “safe” investments. We’ll say for this example, 5% a year.

The bank then takes the investor’s $1 million, with a borrowed $19 million–or $29 million, or $39 million or whatever. $19 million in this example–and invests the pool of $20 million and lend it out–buying up mortgages that pay 6% a year, in this example.

If everything goes well, since the mortgage holders are paying you 6%, there is a tidy return (the dark gray) to be split. Part goes to pay the 5% owed (the dark blue) to the Money Market fund investors. The rest goes to the holder of the original $1 million–to the tune of a whopping 26% annual yield (the dark brown.)

Well, what if the mortgages don’t pay as well as hoped? The bank’s original pool of $20 million invested ($1 million of the investor, $19 million borrowed) is now less than the start.

This is a huge problem, as the Money Market people must be paid back both the principle and interest–or the bank’s credit rating, and access to this pool of money to borrow from, will be lost. So, when this is rare, the investment bank covered the difference itself, making it appear to the Money Market investors that their money was not lost.

The higher the leveraging–the more money borrowed to that collected from an investor–the greater the chance that the money borrowed cannot be paid back. From the Great Depression to the late 1990′s, this ratio was strictly regulated, and kept low. Gramm–the architect of McCain’s economic plan–was key in getting rid of any limit on the ratio.

Well, what if many of these schemes all fail at once, like happened this month? The banks ability to make up the difference would be overwhelmed. The Money Market managers would have to be told their money was gone. The bank’s credit would be trashed. The whole system crashes and burns. Deleveraging.

What to do? Should these banks–and what real social benefit is being done by these schemes?–be bailed out by the taxpayers, their losses covered?

This weekend–after a brief detour through the responsible path and the collapse of Lehman Brothers–the answer turned out to be yes.

Our wallets are being raided, to the tune of about a trillion dollars. To put this in perspective, the entire economic output of the United States, for one year, is about ten trillion dollars. One tenth of an entire year’s work is being poured into the crumbling foundations of Wall Street. And, this possibly will be insufficient to do more than temporarily slow the cascading failure.

Can anyone tell me why banks like this deserve to be saved? Why highly leveraged schemes like this are in any way desirable?

The actions began to get under way on Thursday with discussions between the Treasury, Federal Reserve and Congressional leaders on what could become the biggest bailout in United States history, a plan likely to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions….

In a move against traders who have sought to profit from the financial crisis by betting against bank shares, the Securities and Exchange Commission issued a temporary ban on short sales of 799 financial stocks, following similar action in Britain on Thursday.

And the Treasury, moving to restore confidence in another financial bedrock, said that it would guarantee, at least temporarily, money market funds up to an amount of $50 billion to ensure their solvency, a startling intervention into what had been considered among the safest investments.

For years, I’ve had to put up with conservatives bitching about the moral hazard posed by FDR’s New Deal. Today’s actions reveal these “free market” proponents as gigantic, hypocritical assholes.

Don’t be too shocked.

Want to distill down the New Deal-era financial reforms? If you want our money to bail you out, you have to play honestly and by our rules. If something is important enough to the economy that we’d consider bailing it out, it deserves regulation first, bailouts second.

For example, the Glass-Steagall Acts prevented risky investments from shacking up with the safe–keeping investment banks and commercial banks separate. The same laws created the FDIC insurance of our savings account also limited where and how aggressively insured banks could invest.

Most of Glass-Steagall’s regulatory provisions were written out of law in 1999, setting the stage for our present catastrophe. Today’s “solution” to the present crisis is all bailout, no regulation–the mirror image of FDR’s. It’s going to fail.

“Free market” conservatives–like our current SEC chairman Christopher Cox–for years have been telling us the market will collapse irresponsible companies, relieving the government of the responsibility to actual bother regulating the financial industries. Well, when the irresponsible have started collapsing, Cox and others are right there with our wallet, dumping cash on the table to “restore confidence.” I have an ugly truth for you: confidence shouldn’t be restored in this system.

Want to restore confidence? I have a suggested governmental takeover for you: The entire debt rating industry. If the goal is to calm down global investors, who were burned by “high rated” debt that was anything but good, a public execution of Moody’s and others would be the perfect way to do it.

Take the money we’re now showering on the greatest failures in two generations to pay for a new governmental debt-rating agency. Pay the employees of this agenccy usurious wages–wages beyond any bribe. Grant these employees the right to tear into the books and documentation behind all of the financial derivatives, and give honest ratings to the relative quality of the debt.

With that, I know my confidence would be restored–in more than just the financial system.

is bad.

Anthony, it depends on how abstract you want to be.

When you save money at a bank, most of the money gets lent out to someone else. Look at your account balance. Shift the decimal place one to the left. That’s about as much of your money your bank actually keeps around.

The whole banking system relies upon the notion that:

1. These loan investments (made with your money) will eventually be repaid.
2. Huge numbers of people won’t ask for all their money back at once.

Let’s say 1 ends up being false–say because banks invested in a bunch of secured debt that ends up having no verifiable assets securing the debt. All of your money the bank lent out is gone. Poof.

You come by to cash a check. If we’re living in the the early 1920′s (or the early 2000′s) the following occurs:

You: I want my money.

Bank: One moment sir!

Bank turns from you and cries out.
Bank: Calling all suckers! Please place your money here!

Sucker: Here’s my money!

Bank takes the money and turns to you.

Bank: Here’s your money sir!

You: Thank you!

After the last sucker has been found and fleeced (1929 version):

You: I want my money.

Bank: One moment sir!

Bank turns from you and cries out.
Bank: Calling all suckers! Please place your money here!

No suckers arrive.

Bank turns to you.

Bank: Fuck you, your money is gone.

You: Fuck you! I’m ruined!

After the last sucker, 2008 version:

You: I want my money.

Bank: One moment sir!

Bank turns from you and cries out.
Bank: Calling all suckers! Please place your money here!

No suckers arrive.

Bank turns to the FDIC and asks for a loan. Receives such a loan.

Bank takes the money and turns to you.

Bank: Here’s your money sir!

You: Thank you!

Ready for the trippy part? The FDIC, ultimately, is secured by the full faith and credit of the Federal Government. In turn, the credit of the US Government is secured, well, by you and me. The taxpayers.

The incompetent, failing bank–that has both made huge numbers of bad loans and lost the confidence of new investors–can count on one last big sucker to pay us back. Us.

Heller could not write it better.

My primary bank account is at Washington Mutual. Like everyone else who has money saved at Washington Mutual, I should be concerned. I’m not. My account is FDIC insured. Even if the whole bank goes belly up, as IndyMac just did, up to $100,000 of my investment will be returned to me. Since I’m a Stranger writer / graduate student, I do not even vaguely approach the $100,000 limit. Even if WaMu sinks, I’ll float. Because, through the FDIC, I’ll pay myself back all the money WaMu lost me. With my money, that I pay in taxes.

Well, not exactly. For now, the FDIC is solvent and doesn’t need an infusion of cash from the Federal government. And, while investors are increasingly terrified about lending to banks like WaMu, they continue to buy up US government debt. In other words, the investors have decided most banks are too risky, forcing the banks to borrow from the FDIC instead. The FDIC in turn borrows from the federal government, that in turn borrows from the same frightened investors. Brain hurting again?

Welcome to the land of leaky abstractions.

Anthony, you’re a computer guy. I have the perfect metaphor for you.

TCP, the protocol underlying the majority of the web, absolutely guarantees that a given message will arrive, complete and in order. TCP does this by using IP. IP guarantees absolutely nothing. So TCP makes the promises and attempts to deliver them with IP. Most of the time, it works splendidly.

If someone trips and pulls the ethernet cable out of the wall, TCP will keep making promises that IP cannot deliver.

The banks tripped, and the global investors are pulling their plugs out. We’re promising to honor all debts, by taking the investors’ money to guarantee the investors’ money. It should turn out great, if we collectively believe it’ll turn out great.

Ever since the start of the mortgage crisis–whose origins and effects can be revisited at this post, or on this podcast–I’ve been waiting for the great taxpayer-fueled bailout to begin.

The bailout of Bear Stearns was a mere appetizer to the cliff we’re falling over now:

Government efforts to support mortgage giants Fannie Mae and Freddie Mac drew a restrained response from investors today, with the stock prices of the two companies rising only modestly after last week’s steep collapse, but by midday investors turned to a new target of the credit crisis: banks.

To recap briefly:
1. The investment banks and mortgage markets were effectively deregulated through the 1990′s and 2000′s…

2. …allowing the creation of mortgage backed securities…

3. …that were increasingly backed by shoddier and shoddier mortgages…

4. …making what was once one of the most stable and socially productive investments both incredibly risky and socially catastrophic, with no way for investors really know if and when the transition happened…

5. …leaving the investment banks, mortgage companies, regular banks and even the government sponsored enterprises on the precipice of catastrophic failure in a way not seen since the Depression, when these institutions were last similarly deregulated.

Market theory would tell us the government should not intervene–these institutions should be allowed to fail, the unwise investments allowed to collapse and the money to be lost. At the last height of Laissez-faire economic policy, in the 1920′s, that was the plan. The institutions were allowed to collapse one-by-one, causing the Great Depression.

That didn’t work out so well. In the 1930′s, sifting through the rubble of the US economy, the next plan was regulation. If we think of modern financials as being like junk food–made of many ingredients, intrinsically difficult to discern–knowing the providence of the starting materials really matters. Many of the New Deal regulations did just that–demanding that companies report honestly and completely on their health, that mortgages be attached to information about the borrower indicating an ability to pay and so on.

By making information about investments as honest, comprehensive and accessible, through laws and oversight, investors could avoid the most questionable of financial junk food and thus get fat on the rest. If they did pour money into something obviously dubious, it was far easier to allow the market to do its job, and make the investments as valueless as they had appeared to be. You could easily tell it was crap before you put your money in. You lose it, it’s your loss.

These were the regulations written out of existence, or circumvented, in the years leading up to the present crisis.

Like with junk food, the companies and people doing the processing make most of the profit–making the producers (the investors) and the consumers (the borrowers) pay dearly for participation in the market–all while whining they cannot afford things like complete and honest information about what they are selling. Loan agents eventually stopped checking income, employment, the value of the property or the credit history of the borrower, because the mortgage companies stopped asking the loan agents to collect this information, because the investment banks buying up these loans stopped asking as well. The investors buying from the banks didn’t really care, as the bond agencies gave the blended investments the highest ratings. The rating agencies, increasingly deregulated, didn’t bother asking for this information either. Without it, it was impossible to predict how the loans would perform. They guessed. They were wrong.

Even though only a small percentage of the borrowers failed to make their payments, without information to tell bad from the good investors became spooked. If the rating agencies couldn’t tell the value, how could an investor? The lenders rapidly pulled out of the market. First to fail were the investment banks, stuck with loans they could no longer sell to investors–even if the loans were good. Bear Stearns, such a bank, quickly grabbed a handout from you and I, the taxpayers. Next, the mortgage companies and their related banks start to wobble. Indymac just collapsed, and again the taxpayers are asked to reach into their wallets and pay off the FDIC guarantees.

Which brings us to the bailout of Fannie Mae and Freddy Mac. These are Government Sponsored Enterprises that were created to perform a basic and seemingly unavoidably safe and profitable task: Buy up high quality mortgage loans from banks and package them as securities that can be sold to investors at a profit. In essence, this is the honest version of what all the crooked private companies were doing–in which each loan is carefully vetted and matched to the borrowers ability to pay and the honest valuation of the property. These companies are of vast importance to the entire housing market, allowing banks to make far more mortgages than would be possible if each loan had to stay at the originating bank and not be resold. In the wake of the crooked mortgage-backed securities, investors have stopped buying the Freddie Mac and Fannie May mortgage-backed securities. With no investor money coming in, they can no longer buy up loans. In steps us again, the taxpayers. We’ve now committed our tax dollars to buy up mortgages–money we are ultimately borrowing from the Chinese.

These bailouts aren’t helping homeowners. The dishonest crooks–the loan agents, the investment banks, the rating agencies–are having their asses saved with our tax dollars. And, this is happening without any serious re-regulation, without a strong requirement for honesty and clarity on the financial industry’s part. From any perspective, this is the worst outcome, virtually guaranteeing another huge bailout in a few years. With no concequences, and so many of those well positioned getting filthy rich off the fiasco, why not do it again, and again, and again?

If we force those who demanded deregulation in the financial industry, who took advantage of the deregulation to dupe others, into an honest position, we’d let them all fail, dragging them out of their windows to the hard streets below, to live under overpasses and eat pet food like their parents and grandparents were forced to do during the last time they ran us all off the cliff. We’re too cowardly to do it and will likely pay an even harsher collective price thanks to this cowardice. We’re too frightened to let them fail, and suffer as well. I’m frightened of what the collapse will bring. Our political leadership, long greased with Wall Street money, won’t even demand rules that will truly complicate such thievery in the future. You should be furious.