Ashes In The Maelstrom

The IMF purports to be optimistic after the U.S. and U.K. acted to nationalize banks through direct capital injections. True, Paulson did not intend this even a week ago. But rather than excoriate him for improvising we applaud the flexibility. The question many might ask is why would a direct capitalization overcome fear of lending contra say Fed rate cuts and the open discount window.

Time outpaces ideology or statutes. We were skeptical Paulson could stand up and run auctions in ‘weeks’. We worked with the FCC and industry setting up and implementing the first ever spectrum auctions in the early 1990s and those that followed. Even skipping Reed Hundt and Blair Levin’s Gore-esque GOSPLAN regulatory mania for a down and dirty bare bones gig in 2008, those spectrum auctions each had a defined homogenous res (a specific band of frequencies) compared to current unknowable facility’s toxicity, etc. Even a reverse auction to function must have *some* kind of uniform or at least common baseline, however attenuated. That is simple auction theory 101.

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Some comparable statistics of other economic declines are sobering and possibly reassuring:

The average downturn after recent banking crises in rich countries lasted four years as banks retrenched and debt-laden households and firms were forced to save more. This time firms are in relatively good shape, but households, particularly in Britain and America, have piled up unprecedented debts. And because the asset and credit bubbles formed in many countries simultaneously, the hangover this time may well be worse.

But history teaches an important lesson: that big banking crises are ultimately solved by throwing in large dollops of public money, and that early and decisive government action, whether to recapitalise banks or take on troubled debts, can minimise the cost to the taxpayer and the damage to the economy. For example, Sweden quickly took over its failed banks after a property bust in the early 1990s and recovered relatively fast. By contrast, Japan took a decade to recover from a financial bust that ultimately cost its taxpayers a sum equivalent to 24% of GDP.

All in all, America’s government has put some 7% of GDP on the line, a vast amount of money but well below the 16% of GDP that the average systemic banking crisis (if there is such a thing) ultimately costs the public purse. Just how America’s proposed Troubled Asset Relief Programme (TARP) will work is still unclear. The Treasury plans to buy huge amounts of distressed debt using a reverse auction process, where banks offer to sell at a price and the government buys from the lowest price upwards. The complexities of thousands of different mortgage-backed assets will make this hard. If direct bank recapitalisation is still needed, the Treasury can do that too. The main point is that America is prepared to act, and act decisively.

All of which leads to the real issue: What Comes After. As The Economist notes “If foreigners ever flee the dollar, America will face the twin nightmares that haunt emerging countries in a financial collapse: simultaneous banking and currency crises. America’s debts, unlike those in many emerging economies, are denominated in its own currency, but a collapse of the dollar would still be a catastrophe.”

The American ability to inflate our way out of our own stupidity is a short term Sword of Damocles over the IMF meeting this weekend in Washington and among the EU leadership. We agreed with Spengler before in an earlier post — Asian and European alternative capital architectures are not yet in place. It is, however, just a matter of time.

The Warlord destroyed the ‘American’ brand across the board. Centuries of brand equity squandered in front of a connected global audience. It will not be coming back by chanting ‘Yes we can’. Footsteps away with the whisper ‘Never again’ will dictate events.

In two debates both the Boy King and McCain avoided answering how this crisis constrained their options. Perhaps it is good politics to deny that the United States is a bankrupt hegemon. Even so, neither of them shows the necessary leadership to prepare the American people for the real hardship to come: life as a debtor nation in a post U.S. global financial system.