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Diary of a Tree Stump

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RIP Credit as Money


Wednesday January 28, 2009

by Eugene Linden

The drumbeat about the Obama administration’s plans to fix the banking crisis has reached fever pitch. Over the past week, what appears to be a carefully choreographed series of leaks has raised expectations that the administration has something very big planned (my guess is that it would have been announced right after the inauguration, but for the delay in Timothy Geithner’s confirmation as Treasury Secretary). Various newspapers and blogs have speculated on the details, some of which would be truly dramatic: e.g. an omnibus take-over of a raft of banks, a process that would include wiping out existing shareholders, converting debt to equity (to avoid the new N-word – nationalization), the FDIC providing a backstop for deposits, and, to restore trust in bank balance sheets, the establishment of a new entity to buy, hold, and trade trillions of dollars in now-suspect bank assets.

Clearly something needs to be done, and just as clearly the banks have gotten wind of the proposals and are trying to head off the scariest parts of the plan (I interpret the trumpeted insider share purchases by Chase’s Jamie Dimon and execs at B of A to be a message: “hey, no need to nationalize us, we believe in our equity value!”). Ignored by much of the commentary, however, has been a small but crucial change in the proposed composition of the much-discussed new entity to buy toxic bank assets. Moreover, if this entity comes to pass, it will serve as the grave for a widely shared, but very dangerous artifact of the bubble years: the confusion of money as credit.

First the new wrinkle in the “bad bank” concept. Last week on CNBC Sheila Bair, the outgoing and incoming head of the FDIC, remarked on the possibility of setting up an entity funded by both public and private money to buy toxic assets. The involvement of private money is new, and the timing of this announcement begs many questions. In the CNBC interview Bair said, “One approach we think might have some merit is what we call an “aggregator bank” where you would set up a facility capitalized through some portion of the T.A.R.P. fund to acquire troubled assets…” So far so good, the basic idea has been floated many times over the past year. But then she remarked that the new structure would… “also require those institutions selling assets into this facility to contribute some capital cushion themselves…”

The suggestion about lenders having a stake in the entity is both crucial and new -- at least new to the Bush administration (a number of observers, including me, suggested such an entity at the beginning of the crisis in Aug. 2007: https://www.huffingtonpost.com/eugene-linden/collapse-of-a-fiat-curren_b_60562.html). Forcing banks to have skin in the game alongside taxpayers makes it less likely that financial institutions will try to screw the taxpayers. Having the government involved also provides adult supervision in the setting of the ground rules.

Why then didn’t the Bush administration put forth this key provision before the very end? Someone must have suggested it -- after all, it’s little more than common sense. If it’s a good idea in the full teeth of the crisis, why wasn’t it a good idea at the outset? That it will be the Obama administration that launches this entity implies that the Bush administration was loathe to push for the self-policing aspects of having the banks provide capital.

And then, there’s the end-of-an-era aspect of plan. Whether it’s called a “bad bank” or “aggregator” or “RTC II,” the new entity represents an explicit admission that no one else is willing to accept trillions of dollars in credit instruments that two years ago were treated as interchangeable with money. Thanks to the ingenuity of Wall Street’s rocket scientists, so-called structured credit products proliferated wildly during this decade, backed by mortgages and other obligations (or by other credit instruments that in turn were backed by assets). With credit rating agencies blessing these products as AAA, these instruments were treated almost as money, and provided much of the liquidity that spurred the illusion of wealth creation during the bubble years.

Now, pension funds, hedge funds, endowments, and financial institutions that confused money and credit have discovered -- in the most brutal fashion -- that the value of anything deemed to be money-good rests entirely on the willingness of someone else to accept it. With no one but the government willing to accept these assets, this former currency will be retired as scrap. RIP money as credit.

Unfortunately, the story does not end there. While officials cross their fingers that these disgraced credit instruments will remain quarantined, this nuclear waste could still leach into the financial system, particularly if the prices paid are above market (whatever that is!). The scale of this pollution is such that the sum total of government guarantees and obligations may impact the value the rest of the world puts on the U.S. dollar, the linchpin of the global financial system. In the end then, money and credit do turn out to have some something in common: the value of either depends entirely on the trust of strangers.

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Short Take

THOUGHTS ON WHY THE EARLY IPCC ASSESSMENTS UNDERSTATED THE CLIMATE THREAT

 

An oped involves extreme compression, and so I thought I’d expand on why I think the initial IPCC reports so underestimated the threat. Make no mistake, the consensus in the summaries for policy makers in the first two assessments did underestimate the threat. The consensus was that permafrost would be stable for the next 100 years and also that the ice sheets would remain stable (there was even a strong sentiment at that time that the East Antarctic sheet would gain mass). Moreover, in 1990, the concept of rapid climate change was at the periphery of mainstream scientific opinion. All these things turned out to be wrong

Of course, there were scientists at that time who raised alarms about the possibility of rapid climate change, collapse of the ice sheets, and nightmare scenarios of melting permafrost, but, fairly or not, the IPCC summary for policy makers was and is taken to represent the consensus of scientific thinking.

In my opinion such documents will always take a more conservative (less dramatic) position than what scientists feel is justified. For one thing the IPCC included policy makers, most of whom were more incentivized to downplay the threats. For another, many of the national governments that were the customers for these assessments barely tolerated the exercise and gave strong signals that they didn’t want to see anything that called for dramatic action, and this being the UN, there was a strong push to present a document that as many governments as possible would accept.

And then there is the nature of science and the state of climate science at that point. There is an inherent structural lag built in to the nature of science. For instance, the 1980’s were marked by the rapid development of proxies to see past climate changes with ever more precision. By the mid-late 80’s the proxies and siting had been refined sufficiently that the GISP and GRIP projects could confidently get ice cores from Greenland that they felt represented a true climate record and by then they also had the proxies with the resolution to see the rapid changes that had taken place in the past. Given the nature of data collection, interpretation, peer-review and publishing, it wasn’t until 1993 that these results were published.

It took nearly another decade for this new, alarming, paradigm about how rapidly global climate can change to percolate through the scientific community, and, even today, much of the public is unaware that climate can change on a dime.

As for the ice sheets, when I was on the West Antarctic Ice Sheet in 1996, there was talk about the acceleratio of  ice streams feeding the Thwaites and Pine Island glaciers, but the notion that there might be a significant increase in runoff from the ice sheet over the next hundred years was still very much a fringe idea.

With permafrost, the problem was a sparsity of data in the 80s and early 90s and it is understandable that scientists didn’t want to venture beyond the data.

The problem for society as a whole was that the muted consensus on the scale of the threat diminished any sense of urgency about dealing with the problem. Perhaps the best example of this was the early work of William Nordhaus. Working from the IPCC best estimates in the early 1990s Nordhaus published one paper in which he predicted the hit to the US GDP from climate change in 2100 would be about ½ of 1%. Nobody is going to jump out of their chair and demand action if the hit to the economy was going to be 0.5% of GPD a hundred years laterLibertarians such as William Niskanen seized on this and testified before Congress that there was plenty of time to deal with global warming if it was a threat at all.  

And then there was the disinformation campaign of industry, particularly fossil fuel lobbyists, as well as pressure from unions (the UAW in particular) and the financial community. These highly motivated, deep-pocketed interests seized on scientific caution to suggest deep divisions among scientists and that the threat was overplayed. Little wonder then that the public failed to appreciate that this was a looming crisis that demanded immediate, concerted action.

 



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