Fiscal crisis 101

The following is from the TwShiloh economic correspondent who was nice enough to answer some questions I had about the origins of our current financial…challenges.  I include it here because I found it not only incredibly interesting but also accessible.  So, assuming that some of you might be just as interested I include it here.

So, my question was:

Granted ‘to big to fail’ is a terrible system but isn’t that where we found ourselves in 2008?

I keep hearing economists say what we need now is more stimulus and not belt tightening (but, of course, that’s off the table).  But there are some that are arguing that not only should we be belt tighten but that had we not done anything in 2008 the economy would be in great shape now.

Even more basic than that, though…doesn’t it depend on if you buy into Keynesianism or some other school of economic thought?  I mean, in 2008 when it got real bad real fast, it seemed the question was ‘How do we stop this from getting worse’ with the assumptions:

  1. the credit market is freezing up
  2. everyone is so freaked out they’re hording whatever money they have
  3. we’re on a precipice of a total global financial shutdown.

If I understand the current conservative line of thought it basically says ‘Let it go and it’ll all work out.’

The ‘conventional’ (?) wisdom was:  we need to pump a lot of money into the economy and keep key businesses afloat to restore confidence and allow existing financial systems chugging along.  Reform can come after the crisis.

So, I guess I’m not sure a) if those assumptions were reasonable, b) what a ‘global financial meltdown’ would mean practically, c) if the ‘do nothing’ approach was a reasonable response and d) were there other alternatives?

And here is his response:

First things first. The bailouts started under the Bush administration as encouraged by all of the ex-Goldman execs within and near the govt. Chief among them is former Goldman exec Henry Paulson, who pursued the ‘declare Apocalypse and throw money at Wall Street’ strategy. He appointed former Goldman VP Neel Kashkhari to oversee the $700 billion TARP fund. Anyway, see below for that laundry list of close ties and infiltrators.* The only reason I bring that up, is the ‘conservative’ approach (the Republican approach), was to pass the bill from Wall Street to the citizens. Ok, let’s look at the great points you raised and examine them.


  1. the credit market is freezing up
  2. everyone is so freaked out they’re hording whatever money they have
  3. we’re on a precipice of a total global financial shutdown.


a) if those assumptions were reasonable

b) what a ‘global financial meltdown’ would mean practically,

c) if the ‘do nothing’ approach was a reasonable response and

d) were there other alternatives?

Credit Markets Freezing Up

This was not only reasonable, it was a fact. When banks fear the creditworthiness of each other, they are unwilling to trade very short term instruments called swaps. These are the tools used to generate interest on large sums of money held by very large corporations. Example – Coca Cola doesn’t keep its payroll funds sitting in a bank account. It holds paper – very short term commercial paper. It is effectively loaning it’s money to other institutions via the banks to generate some yield. The maturities might be weeks or days. If the banks lose faith, they won’t lend their assets to other banks with customers who want to borrow the funds. The result is a little like musical chairs. When the big banks stop playing, there’s no one left to generate the notes to trade. So large corporations were caught without true cash reserves. This was (and IS) compounded by the fact that some of what little ‘cash’ these companies held was in overseas investments (again to get better yield). That restricted liquidity. So companies had to raise cash – fast – to simply pay bills. Example: Warren Buffett bought $3B worth of GE preferred shares that paid 10% interest – because GE was desperate. There is no doubt that everyone was freaking out. And we were indeed on the verge of a global financial crisis. I think we still teeter there to one degree or another.

The system seized up, not because all banks were uncreditworthy. But because no one knew which banks were unworthy. The answer was NOT to throw money into the system, but to guarantee certain transactions and liquidity while the banks unwound their bad investments. Guarantee counterparty risk for the swaps, or better yet, become the temporary bank of last resort as the government itself. Open a window and provide LOANS (not gifts) with real interest rates and top priority in the capital structure – ahead of every other stock or bondholder. Example: GE needs $$, but banks won’t lend. So GE goes to the govt. and borrows $3B at a reasonable rate and that loan is the FIRST in line to recover assets should the company default. Subordinate all the other stakeholders immediately. Then, as GE recovers, it can pay off the debt as it wishes. If the company’s balance sheet is SO bad, because it holds too much junk listed as assets (the mortgage backed securities and straight up bad loans made by GE Capital), then the company must trim other obligations to stabilize the balance sheet. Instead of adding public dollars to the asset side, the company should default on its bond payment obligations. If those bonds were wiped out – either through a traditional corporate bankruptcy or lesser restructuring, the balance sheets might balance. In many cases they would have. I’ve heard that would have been the case if GM restructured its bond debt.

In this scenario, we’d have a LOT of upside.

1)      The fixes would all be based on existing laws – bankruptcy laws, etc. This provides precedence, consistency, justice and predictability. Also, accountability.

2)      There would be VERY little public risk. There WOULD be a lot of investor losses. But isn’t that part of the deal as investors?

3)      The culpable institutions as well as the victims would be dismantled and replaced with new firms under new management. And there might actually be a lesson learned that taking these ridiculous risks is NOT worth it. Boards of directors might wake up. Executives might be more attentive.

4)      The recovery would be genuine. It would take a little time (maybe less than the current plan will take), but the strength of our system would regrow more like a healed broken limb and less like a boxer jacked up on speed to finish the fight (and then collapse).

I don’t think ‘do nothing’ was ever an option. It got too bad to ignore. In fact, it only got so bad BECAUSE it was ignored so long. But I think a rational, legal unwinding of the institutions that placed themselves in such direct jeopardy would have been much better for us as a country. It would NOT have been better for the elite few who actually profited from the inflation and subsequent bursting of the bubble. Nor would it have been better for the profiteers who made out like bandits in the midst of the panic and chaos. But their interests have been prioritized not only above the other 90% of Americans, their interests were placed above our national security, our reputation and indeed, our very sense of justice and fairness.

Side note: I’ve read that despite the ridiculous profits the banks have made over the past year (borrowing money from the fed for free and then using hat same money to buy treasuries which pay interest risk free), most of the large banks in this country would be completely insolvent if they had to mark their assets to market. Right now, they are allowed to value their assets based on their own estimates – which are most likely MUCH higher than the real value. So, while the balance sheets are skewed by fake numbers of the asset column, and the banks are making massive profits at the direct expense of the public (who pay the interest on the treasuries), they’re setting records for executive bonuses.

By the way, not dive too deeply into the grit, here’s an article on the way these investment banks played their hands with the shady mortgage backed bonds. They were eyes-open and playing full-contact rape. They should have gone out of business and their collective demise might serve as a lesson to future management teams. Instead the only lesson is that crime pays VERY well.


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