Tuesday, February 24, 2009

Attack of the zombies

The U.S. banking system right now is a collection of zombies, insolvent empty shells that are not performing the most basic functions of a bank. As a response, there is a call on the part of some to just let them go bankrupt and collapse the way any other bankrupt company would be dissolved in Chapter 13.

There's one problem with that: A capitalist system requires a stable money supply, a money supply that maintains price stability and wage stability. Money has value only insofar as it can be traded for things you can eat or drive or wear or live in. If you change the amount of "stuff" that you can trade money for, you render a lot of contracts broken. A loan contract, a contract to buy fuel oil for your trucking fleet, etc. all assume dollars that buy a fixed amount of "stuff". If you expect them to be paid in deflated dollars that buy more "stuff", then you've broken the contract in favor of the lender. If you expect them to be paid in inflated dollars that buy less "stuff", then you've broken the contract in favor of the borrower. The problem is that our legal system is based around the notion that dollars have a constant value, thus doesn't know how to deal with this situation other than to enforce contracts that now are unfair to either the lender or borrower. The legal system could be repaired, I suppose, to deal with the changeable nature of the value of a dollar, but it's far easier to simply maintain the value of a dollar at the amount predicted at the time the contract was written -- which is around 2% inflation per year.

So what does that have to do with zombie banks and why we can't just allow them to take Chapter 13 dissolution, you ask? Well, it's simple. Banks are unlike any other business in that they print money via the action of fractional reserve lending. So if you simply dissolve a bank, you basically un-print all the money which it has printed. That causes deflation -- the same amount of "stuff" in the economy but less dollars, meaning each dollar can buy more "stuff". Which, as pointed out in the previous paragraph, is unfair to borrowers and can result in a deflationary spiral if the borrowers cannot repay their debts in the now-deflated dollars, therefore defaulting and causing yet more banks to collapse and un-print the money they printed, wash, rinse, repeat, until we're all living in cardboard boxes except for the rich and wealthy who will own everything, purchased for pennies on the dollar.

In short, simply allowing the entire banking system to collapse will trigger a deflationary spiral that will impoverish the debtor class (us) and enrich the creditor class (the wealthy). So the only solution has to be to take over the banks, write down all the bad stuff to what it's really worth (e.g. all those CDS's? $0 value. All those non-Freddie-Fannie MBS's? Write'em down to $0. all those ARMs that will reset to 25% interest? Nope, worthless, either write'em down to 5% interest and value them at what they're really worth, or just write them off entirely) and toss'em off to a "bad bank" 100% owned by the government which can then collect whatever (if anything) ever gets collected on them, and fit the skin of the zombie around a fresh newly-capitalized bank that is 100% solvent. For that matter, all those ARM's and balloon mortgages? Pass a law outlawing ARM rate resets and extending balloon mortgages to 30 years at the same time you pass the law nationalizing the banking system, and revalue the loans accordingly when you transfer them to the "bad bank". The ARM's are worthless if you let the rate reset anyhow, if you foreclose on the house you can't sell it for anything near the value that you'll get from the un-reset ARM, so it's time for the investor class to just take their lumps and move on.

So the next question is: Where does the money come from to do this? Won't doing this impoverish all of us anyhow just as much as the zombie banks collapsing would? Well... the Federal Reserve possesses this marvelous technology called the printing press. Yeppers, they can just print fresh money to replace the money un-printed by collapsing all those bad debts into the "bad bank". But won't this cause inflation, you ask? Well, you need to go read Ben Bernanke's speech from last Wednesday again (previously linked). The Federal Reserve has many mechanisms for monitoring the money supply and inflation rate, and many mechanisms for un-printing money if necessary, ranging from market operations to increases of reserve requirements to raising interest rates. So this doesn't necessarily end up with runaway inflation. But I'll just point out that inflation is not the worst thing that can happen for you and I, members of the debtor class, anyhow. Inflation has the effect of reducing the real value of our debts (that is, the amount of "stuff" buyable with the money we owe), and thus makes them easier to pay off. In the long run inflation kills an economy because it encourages spending rather than saving and investing, but in the short run a little inflation may be just what the doctor ordered for the economy.

So one final question: Why bother putting the zombie skin around new banks? Why not just create new banks from whole cloth? Well, the problem there is that people have deposited their money at specific banks. Putting the zombie skin around the new banks lets those people handle their money transparently as if "their" bank still actually exists, rather than having to figure out where their money went to when their bank was taken over by the "good bank". It's simply less disruption than just throwing out the zombie skin. And less disruption is a good thing when we're talking about something as important to the country as a functional banking system. Capitalism requires a functional banking system, a dank dreary island nation ruled the world for almost 100 years because it was the first nation to create a modern banking system (yep, banks literally created the British Empire, since it allowed leveraging current income to purchase an empire that more than paid back the loans that created it), and making sure we have one and that it operates smoothly has to be one of the most important goals of the next couple of years. Capitalism sucks, but everything else sucks worse because chaotic systems such as an economy cannot be modeled by any algorithmic processes and thus use of a token system to "train" the economy to produce the goods and services most valued by the populace is the only really effective means of matching goods and services with the demand for goods and services. But that token system only works if a) the rules used to train it are fair to all participants (which has been a problem recently), and b) the tokens used to train it -- money -- have a constant or predictable value. The latter of which requires a functioning banking system. Which sucks, but so it goes.

-- Badtux the Economics Penguin

1 comment:

  1. That helps my understanding a bit.


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