The switchboards at Congress were tied up this week with the public outrage at the bailout (notice how it's now called a "rescue" plan?).

Two responses:

1. The DeLong proposal is similar to the Chilean solution in the 1980s of loaning the banks the money, calling it capital, and requiring them to repay with interest, while not being allowed executive bonuses or the ability to pay dividends for the duration, as I posted earlier. It's all funny money anyway. The banks enjoy substantial rents from being granted money-creation priviledges, and are so highly regulated they are practically government agencies anyway. "Nationalization" in this sense is just another way to keep insolvent institutions open. The important behavioral point is not to reward moral hazard. The Paulson plan is exactly the worst plan for this reason, but then, as our host has pointed out, Paulson's conflicts of interest are manifold.

We'll see what our puissilanimous elected representatives come up with this weekend. There have been contrarian statements issued by some real heavyweights.

2. On the larger questions of how much outright gangs of crooks are running the show, if you want a shrewd, really pessimistic view (one of many, this one from a COINTEL guy), see John Robb's Global Guerillas blog, excerpted here (welcome to the jungle; see also Strauss and Howe's The Fourth Turning on the crisis/depression generation):

Monday, 22 September 2008
ONWARD TO A HOLLOW STATE

The modern nation-state is in a secular decline, made inevitable by the rise of a global market system. Even developed nations, like the US, are not immune to this process. The decline is at first gradual and then accelerates until it reaches a final end-point: a hollow state. The hollow state has the trappings of a modern nation-state ("leaders", membership in international organizations, regulations, laws, and a bureaucracy) but it lacks any of the legitimacy, services, and control of its historical counter-part. It is merely a shell that has some influence over the spoils of the economy. The real power rests in the hands of corporations and criminal/guerrilla groups that vie with each other for control of sectors of wealth production. For the individual living within this state, life goes on, but it is debased in a myriad of ways.

The shift from a marginally functional nation-state in manageable decline to a hollow state often comes suddenly, through a financial crisis. This crisis typically has the following features:

* Corporations and connected individuals systematically loot the nation-state of financial assets and natural resources through a series of insider/no cost deals. These deals are made to "save" the nation's economy or financial system from collapse.
* Once the full measure of the crisis is known, the nation-state's currency falls precipitously, it's debt becomes expensive, and it is forced to submit to international oversight/rules.
* The services the state provides rapidly evaporate as its bureaucracy is starved for cash/financing. This opens up a window for the corruption of government employees unused to deprivation.

The Dynamic of Primary Loyalties

The decline from functional but weak nation-state is extremely sudden. For individuals, there is a rapid and sustained decline in the standard of living. Additionally, there are spot shortages of critical items and commodities -- particularly food, medicine, and energy (since these are globally fungible). Large and small business fail across the board, or become prey to connected companies/individuals with access to the remaining coercive power of the nation-state. As the deprivation becomes commonplace, people turn to primary loyalties for support and services -- loyalties to a corporation, tribe, gang, family, or community. These groups, energized by new levels of loyalty but deeply obligated to reciprocate this loyalty with support, become extremely aggressive in pursuit of their survival. Once this shift in loyalty is made, a self-generating cycle of violence, crime, and corruption (fueled in large part through connections to the global market system) becomes entrenched. The nation-state, at that point, becomes irretrievably hollow.

The Looting

It's instructive to view the US Treasury's plans for a bail-out of the global financial system through the lens of the hollow state. By this measure, the bailout as it stands today, is a form of financial looting of the US Treasury (it isn't socialism, since the government isn't nationalizing the financial system). Trillions of dollars in government monies ($700 billion to begin with) will be infused directly into the coffers of corporations and wealthy individuals (via hedge funds). Specifically, the plan buys toxic assets at inflated prices and sells them back for nearly nothing -- no equity or assets of real value are provided in exchange for the purchase. The national debt will likely grow 20-30% in a single year, with obligations extended to many trillions more in guarantees.

Given this, one potential next step forward is a decline the credit rating of US debt (which radically increases the costs of US borrowing), a collapse in the dollar relative to more stable global currencies, and a rapid decline in government services. Other scenarios achieve the same result with different timing. Regardless, our (the US and the UK) journey to a hollow state has officially begun.

NOTE: Philip Bobbitt got it wrong in his book, "The Shield of Achilles." The prosperous market-state he envisioned through constitutional reform isn't possible. The REAL market-state, the form of governance that that has truly embraced the global market system, is hollow. In effect, a state that doesn't place any barriers between itself and the global marketplace. As a result, the only real opportunities created by the emergence of the market-state are opportunities to steal extreme wealth.

My guess is that either Barack brings us together into a new social contract as a viable response to the crisis epoch, or the USA descends into banana republicdom.

Benign — The post you excerpt captures my mood and my fears all to well. I hope it is overblown. But, as they say, hope is not a plan.

JKH — If we divide interventions explicitly into solvency-folcused and liquidity-focused (which Paulson and Bernanke have not, they have given us no clarity and evolving stories about why and how they expect this to work), why not use the pre-existing mechanism for addressing, that is the central bank? One can argue that there is a liquidity crisis so deep that for the Fed to overcome it, it must expand its balance sheet by $700B and lend freely against. OK.

But if we are addressing liquidity, there is no reason for a permanent transfer of assets from, and potentially a permanent transfer of wealth to, the illiquid institutions. If there is both a liquidity and a solvency crisis as you suggest, and the current plan addresses liquidity, why is TARP as both Buiter and Spaventa suggest a kind of "good start" rather than an unusually flawed approach to the liquidity aspects. The reason we are considering this plan is because Paulson claimed it was "comprehensive", a way to speed ahead of all the stopgaps that have thus far failed. The mild defenders of TARP acknowledge that it is not that, point out (accurately) that it could help a little, but so could a lot of less interventions that are far less radical and fraught with distributional hazard.

The banks are gaming the government, as someone pointed out on Bloomberg recently. They're bluffing in hopes of a handout. So what if the TED spread is 200 bp? Who the f*ck cares? It will come down when nerves calm. I just don't buy that there is a "liquidity problem," just as I never bought that there was "so much liquidity out there" when it was all really debt.

Make the banks solvent at market with the stroke of a pen (call it debt, call it equity, call it high-powered reserves...) and trading will go through the roof. Why can't the Fed increase the size of its balance sheet? It's all funny money.

You got it Rue, the whole thing stinketh.

And as Roubini points out, none of the plans so far address the households' balance sheets. Why should we just bail out the financial institutions [who caused the problem]? If anyone deserves debt forgiveness, it's the poor households. The stench is unbelievable.

JKH — I agree with you about the (financial) insignificance of the question of whether a program is taken from the Fed's balance sheet or the Treausry's. They are ultimately consolidated. And, I am pleased this debate is about a Treasury action, not a Fed actions, at least that compels some democratic process.

But I reject strongly your, and Buiter's and Spaventa's characterization of this as a liquidity intervention. Liquidity issues are properly addressed with loans, whether from the Treasury or from the Fed. What characterizes the current proposal is an insistence that assets actually be purchased, that the US (Treasury/Fed/whatever) bear the risks of ownership of these assets before the banks that voluntarily built or bought them. That is not a liquidity function, period. That is a risk transfer, the true definition of an injection of capital.

Calling this a liquidity operation is simply a mischaracterization, quite frankly a lie, unless the risk of ownership is trivial at the price purchased. It is quite clear from Benanke's discussion of the program that this will not be the case, the Treasury will purchase at prices that might be the "expected value" of the assets under somebody's forecast, but does not include compensation for the incredible downside variance.

That is, by any financially literate definition, overpayment.

The Paulson Plan, then, is an injection of capital at prices that are far too high and include no compensation for risk.

That is not a liquidity operation, it is a wealth transfer.

SRW,

“That is not a liquidity function, period.”

OK. I thought that might have been an objection.

I know you've done some posts in the past about liquidity, including one mammoth exchange with Moldbug (who once more has posted something quite unusual and thought provoking about money on his blog). Don't want to emulate such depth here, but I've been thinking a bit about liquidity lately and come to my own conclusion that there is no categorical definition of liquidity. It is an attribute that is context dependent. I won't define that attribute generally here, but I think you get my approach. You may think of this as a cop out, but bear with me.

In this case, I would use liquidity in characterizing at least two phenomena:

a) The seizure/upheaval of the interbank pricing and lending markets
b) The general chaos and futility of transaction price discovery in mortgage derivative and securitization assets

Thus, I don't use liquidity to characterize the institutional mechanism that acts on the problem of liquidity as I have characterized it. I.e., I don't discard liquidity as the focus of risk and of problem solving, based on whether the institutional action operating on it is a loan or a purchase, in this case.

I also don't discard it based on the degree of credit risk that the actor is taking on in this case. It is a question of degree in an action that normally should involve low credit risk but now doesn't, due to the liquidity environment and the credit conditions underlying it.

One ironic thing about our exchange here, to me at least, is that inevitably when I do read about liquidity, categorical definitions are usually aimed at the liquidity of markets in movement, rather than the liquidity characteristic of institutions or their actions, as it pertains to their asset/liability configuration. I'm actually very aware of the latter in my own experience, and ironically you seem to be thinking more in those terms than the former, when interpreting the liquidity content of the problem we are writing about. Roles have been reversed in that sense, at least in my case.

“That is not a liquidity operation, it is a wealth transfer.”

I think there is a risk of wealth transfer. I also happen to think that the risk not necessarily limited to one direction. Your point about downside variance is fundamental to the pricing problem. Treasury is definitely taking a view with taxpayer dollars. But the reverse auction pricing mechanism is decent. And if downside variance is the determining criterion, why are so many people worried about missing out on the potential upside and insisting on some form of equity participation? Upside seems not to be unthinkable.

I find the general debate about this directional risk aspect to be fiery but binary – the extremely negative skews versus the neutral to possibly positive skews. But there's not much in the way of robust analysis or even summary quantification in either case. I guess people are pretty dug into their binary views on the value of these assets. I don't know. But the perceived potential usefulness of TARP is a function of this.

SRW,

I'm probably guilty of defending the feasibility of the Paulson plan to the point of not thinking through a vision for nationalization or debt/equity swaps, or the relationship between the two. My instinct is that there is urgency to taking whatever the next step is and that the Paulson plan with some modifications is the one that can respond more effectively to the issue of urgency. (And I agree the transparency of the auction process is essential for the taxpayer.) I have trouble visualizing the tactical implementation of nationalization or debt/equity swaps while the asset markets and the interbank markets are so seized up. It seems that the Feds would have to go after some quota of bad assets and knock off a number of institutions until that quota is met. Only then would the market believe in the certainty of systemic solvency to the point where it started to function again. But I just don't know how they would go about identifying the list of candidate institutions and taking action quickly enough, given the uncertainty of asset valuations in these institutions. That's why I see dynamiting the asset logjam as least as a prelude to more targeted capital infusions or conversions.