Deteriorating Balance Sheet at the Fed

This chart with data from late September 2008 shows how sharply the balance sheet of the Federal Reserve had deterioriated towards the end of that month. Though the initial "Paulson Plan" was styled as a rescue of the banks, it was primarily a recapitalization of the Federal Reserve. The imminent demise of the US central bank was among the terrors evoked by US officials in their demand that Congress pass the legislation immediately.

The Greatest Bailout of Them All

This chart, which initially appeared here in early to mid October, attempts to show the relative size of the Paulson Plan’s $700 billion authorization to buy up impaired securities from financial firms; follow this link for a brief history of the various bailouts.

This is a pretty cool chart, but look for it to undergo radical revision in the months and years ahead. That big blob on the right, in all probability, is going to get much larger. The AIG and Fannie/Freddie bailouts really belong in the big blob, and the AIG bailout is now $123 billion (oops, $150 billion) as opposed to the $85 billion first estimated. The Fannie and Freddie total ($200 billion) is the amount the Feds injected into these firms, but in all likelihood will not cover the potential liabilities on the bonds, which could be very large. Ultimate costs for the Savings and Loan bailout of the early 1990s are estimated at $220 billion, of which taxpayers were responsible for $178 billion. But initial estimates were only $20 billion. Funny how that works.

Think back to those initial estimates of the Iraq War's likely cost--No more than $50 billion! It will practically pay for itself!--and you will be in the right frame of mind to assess current governmental expectations. 10/16/08

Update, 11/28/08: I will keep the previous chart up as an artifact of happier days, but the size of the big blob has been advancing fast and furiously. Two separate estimates, one by Bloomberg and the other by the San Francisco Chronicle, give the latest estimates at $8.5 trillion (as of Thanksgiving, 2008). The first chart was put together by Jake of Econopic and given a few finishing touches by Jesse. The table at the bottom is from the Chronicle, via, Tim.

Cash for Trash: The Fed's Balance Sheet

The government's strategy for dealing with the financial crisis, such as it has been, has been to exchange "cash for trash." This is definitely a work in progress, but as of October 8, 2008, this is how it looked. Note the stark contrast with the late September situation. The Federal Reserve is putting on to the government's balance all the bad stuff that was on the banks' balance sheets. You, American taxpayer, are now the proud owner of lots of "toxic paper," in the vast stratosphere of the "inverted pyramid" of derivative invention. Hooray. There is a guide to the acronyms in this report from Cumberland Advisors, where the chart appears.

In early November the Fed Balance Sheet Surpassed $2 trillion, and Dallas Fed President predicted it could surpass $3 trillion by January 2009.

Lee Hoskins, a former president of the Cleveland Federal Reserve Bank, sums up why Bernanke will win no plaudits in the Central Bank Hall of Fame: "The Fed has violated two principal tenets of central banking. First, don't lend to insolvent institutions, and second, don't lend on anything but the most pristine collateral -- and at a penalty rate."

The following chart from the November 22 Barron's, in which Hoskins' grim observation appears, sums up the data as of November 12, 2008. Barron's (which generally has been bullish all the way down, Alan Abelson apart) notes that were the Fed a commercial lender, "it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed's current capital ratio, or capital as a percentage of assets, is 1.9%." Its balance sheet, Jack Willoughby notes, " is as leveraged as any hedge fund's: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%." The loans will "self-liquidate" if the financial crisis eases but will be an albatross if it does not.

Contemplating these unprecedented moves in early October, blogger David Merkel assessed the implications as follows:

"What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from [private to public] hands. That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

* Inflation when the Fed monetizes the debt,
* Depression from vastly increased taxes,
* Debt repudiation (whether internal, external, or both), or
* Japan-style malaise for a long time."

Just how unprecedented the Fed's actions have been is also shown in this graph from West- Coast Whiner (Wcw), who frankly has a lot to complain about but maintains a generally cheery disposition. Notes Wcw: "Any time that a properly normalized series starts rivaling the freaking Depression, you have to worry."

12/01/08

Paulson Plan, circa October 14, 2008

The plans they are a changin'. It's difficult to keep up. The latest iteration has the following features:

"Mr. Paulson said the Treasury would make $250 billion available to banks to help recapitalize those banks and to get them lending again, among themselves and to businesses and consumers.

In addition to injecting money into the banks, according to the plan, the United States would also guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers.

The F.D.I.C. would also offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses — bringing the United States in line with several European countries, which have adopted such blanket guarantees.

And the Federal Reserve would start a program to become the buyer of last resort for commercial paper, a move intended to help businesses get the money they need for day-to-day operations.

On Monday, big banks agreed to take investments totaling about $125 billion. Citigroup and JPMorgan Chase will receive $25 billion each. Bank of America, which is acquiring Merrill Lynch, and Wells Fargo, which is acquiring the Wachovia Corporation, will receive $25 billion. Goldman Sachs and Morgan Stanley will receive $10 billion each. And Bank of New York Mellon and State Street will get $2 billion to $3 billion.

Another $125 billion is allocated for thousands of small and midsize banks. They will be eligible for government investments reflecting a similar proportion of their assets." (NYT, 10/14/08)

Update, 10/19/08:

This New York Times chart shows government commitments going off a cliff.

Zingales is a Hero; Paulson is a Lout

Luigi Zingales offers a plan far superior to that which Secretary of the Treasury Henry Paulson announced on October 14, 2008. The latter is an unconsionable bailout of firms that made extremely bad choices. That a public bailout should be offered without detriment to shareholders in financial firms--they of the absurd business models and catastrophic miscalculations--is a scandal. It is especially obnoxious because Paulson has a personal stake in the outcome and perpetrated himself while at Goldman Sachs many of the abuses now coming acropper.

The intellectual failure to offer rebuttals to competing plans or to give them serious consideration is a pathetic commentary on the quality of US economic leadership. Scare-mongering and threats of economic terrorism just about exhaust their arsenal of argumentation.

Congress ought not to have given Paulson what is essentially a blank check. It is their failure, too.

As compared with the Paulson plan, Zingales's proposal is a much better deal for the public, more respectful of basic principles of free enterprise, and more efficient in returning to a more normal credit environment.

The essence of the Zingales approach is to facilitate a process whereby insolvent firms are recapitalized in a two step process: existing shareholders are wiped out, as is the basic rule in treating with insolvent firms, and bondholder claims are converted from debt to equity. That constitutes an immediate recapitalization, addresses the fundamental problem of the debt overhang, and would allow a faster return to credit market stability than the approach the US government has favored. It is also far more consistent with elementary principles of justice and law. It is only a sort of “money grows on trees” attitude, and the ability of policymakers to confuse the public with a shell game in which true costs are minimized, that allows this to proceed. It has enormous opportunity costs.

The following extract from Zingales describes how governmental action could facilitate this recapitalization. His approach is a terrific example of the contribution that professional economists can make to public policy, combining an intricate knowledge of market incentives with shrewd legislative proposals that both facilitate the public good and affirm fundamental principles of law and justice. In light of the abuse that economists have received, even from within the breed itself, it remains important to remember that we depend upon the various geniuses resident within the profession to help us find a way out.

You should read the whole thing, but here is an extract from Luigi Zingales on how to recapitalize the banks.

"The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equity-holders wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

Certainly, some current shareholders might disagree that their bank is insolvent and would feel expropriated by a proceeding that wipes them out. This is where the Bebchuk mechanism comes in handy. After the filing of the special bankruptcy, we give these shareholders one week to buy out the old debtholders by paying them the face value of the debt. Each shareholder can decide individually. If he thinks that the company is solvent, he pays his share of debt and regains his share of equity. Otherwise, he lets it go.

My plan would exempt individual depositors, which are federally ensured. I would also exempt credit default swaps and repo contracts to avoid potential ripple effect through the system (what happened by not directing Lehman Brothers through a similar procedure). It would suffice to write in this special bankruptcy code that banks who enter it would not be considered in default as far as their contracts are concerned.

How would the government induce insolvent banks (and only those) to voluntarily initiate these special bankruptcy proceedings? One way is to harness the power of short-term debt. By involving the short-term debt in the restructuring, this special bankruptcy will engender fear in short-term creditors. If they think the institution might be insolvent, they will pull their money out as soon as they can for fear of being involved in this restructuring. In so doing, they will generate a liquidity crisis that will force these institutions into this special bankruptcy.

An alternative mechanism is to have the Fed limit access to liquidity. Both banks and investment banks currently can go to the Federal Reserve’s discount window, meaning that they can, by posting collateral, receive cash at a reasonable rate of interest. Under my plan, for the next two years only banks that underwent this special form of bankruptcy would get access to the discount window. In this way, solid financial institutions that do not need liquidity are not forced to undergo through this restructuring, while insolvent ones would rush into it to avoid a government takeover.

Another problem could be that the institutions owning the debt, which will end up owning the equity after the restructuring, might be restricted by regulation or contract to holding equity. To prevent a dumping of shares that would have a negative effect on market prices, it is enough to include a norm that allows these institutions two years to comply with the norm. This was the standard practice in the old days when banks, who could not own equity, were forced to take some in a restructuring.

The beauty of this approach is threefold. First, it recapitalizes the banking sector at no cost to taxpayers. Second, it keeps the government out of the difficult business of establishing the price of distressed assets. If debt is converted into equity, its total value would not change, only the legal nature of the claim would. Third, this plan removes the possibility of the government playing God, deciding which banks are allowed to live and which should die; the market will make those decisions."

That's actually the second part of the Zingales plan. The first part addresses how to deal with the housing bust, which finds so many homeowners "underwater,” that is, owing more on their homes than they are worth. In the old days, renegotiation could take place between a bank and a mortgage holder, but that is not possible today because of “securitization.”

Here's the key element in the plan: “Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.”

Utilizing the Case-Shiller index measuring house price changes at the zip code level, “the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.”

In exchange, “the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.”

“The reason for this sharing of the benefits is twofold. On the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

Since the option to renegotiate (offered by the American Housing Rescue & Foreclosure Prevention Act) does not seem to have been stimulus enough, this re­contracting will be forced on lenders, but it will be given as an option to homeowners, who will have to announce their intention in a relatively brief period of time.

The great benefit of this program is that provides relief to distressed homeowners at no cost to the Federal government and at the minimum possible cost for the mortgage holders. The other great benefit is that it will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions’ balance sheets.”

My comment: I have a child-like enthusiasm for Zingales' plan to recapitalize the banks. About his plan to re-negotiate mortgages I am not so sure. I am thinking it could probably be improved, but am sure I am not the fellow to improve it.

Some questions for students to consider for a tutorial paper: what is the impact of the plan if we assume differing levels of house depreciation? Taking, say, a 20%, 30%, and 40% decline in housing values, what would be the implications for the economy of this workout? What are the major alternatives to this plan? How does it differ from the government's approach and from that of Obama and McCain? What are strengths and weaknesses? Assess this not only in relation to "efficiency"--how to get the economy moving again--but in relation to traditional principles of law and justice.

11/01/08

The Major Scandal

Willem Buiter (of the Financial Times and the LSE) nicely diagnoses the major scandal entailed in Paulson's plan to recapitalize the banks.

Buiter argues that the US taxpayer is getting a “terrible return” from Paulson’s promise to supply $250 billion to the banks, “bound to rise to probably around twice that amount.” It is basically a “free gift.” In Paulson’s program, “the injection of capital is through non-voting preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injection into Goldman Sachs).” There are also no attractively valued warrants; the shares “can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks.” Unlike in Belgium, the government gets no vote even as it ponies up the funds. Unlike in Britain, whose preference shares get a 12 percent yield and board members, the US taxpayer gets a 5 percent yield and no say in the running of the firm.

The major scandal, as Buiter notes, is that neither in the latest iteration of the Paulson Plan nor in the bailouts of AIG and Freddie and Fannie did unsecured senior creditors have “to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out” of each bailout whole. “There were no up-front haircuts, charges or mandatory debt-to-equity conversions.”

Buiter emphasizes the “moral hazard” objection to proceeding in this vein, arguing that “we are laying the foundations of the next systemic crisis” by this conduct. That may be—it is indeed a horrible precedent--but the far larger point is simply that the whole proceeding upends and makes a total mockery of basic principles of bankruptcy law. It’s as if the shareholders of an insolvent firm decided that they were going to simply make off with all the excess cash and potted plants, stiff their creditors, and waltz away unimpaired. You can’t do that. There is an order to these things. There are several laws on the books against it. That shareholders must suffer first from insolvency, with the creditors picking up the scraps, is like some sort of first principle, is it not? Yet the US government’s policy violates this principle and allows both shareholders and creditors to gain unfair advantages at the expense of the public.

There is a proper role for the state as the “lender of last resort” in panics; it is not the idea of government intervention that is objectionable. The government should probably be willing to commit public funds and guarantees in a supplementary vein in the aftermath of the bankruptcy and recapitalization procedure that Zingales calls for. To do so in the first instance, however, is a simple fraud on the public, a great crime committed in broad daylight. 10/24/08

David Merkel also makes the key point, though somewhat tentatively: "I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity. This extinguishes debt claims, and accelerates the healing of the economy. This would be true reform." Right. It would have been clearly better! 10/25/08

Buiter continues to hammer away at the absurdity and incompetence of the government's approach, as the AIG price tag rises to $150 billion. 11/11/08

Robert Reich aptly calls it "Lemon Socialism." He rightly wonders why the shareholders of insolvent firms "should not be cleaned out first, and their creditors and executives and directors second -- before taxpayers get stuck with the astonishingly-large bill." The powers that be have crafted an absurd form of political economy in which "taxpayers support the lemons" and "capitalism is reserved for the winners." 1/24/09

Here are some additional links sympatico with this general line of criticism:

Blodget, "Why are We So Afraid to Fix the Banks the Right Way?" 1/19/09

Tilson, "Preventing the Greatest Heist in History," 1/20/09

Last Resort

There is a passage in Bolingbroke, an eighteenth century British sage much admired by John Adams, which expresses nicely a precept of statecraft relevant to the financial crisis. The problem illuminated concerns the respective roles, in threatened insolvencies, of shareholders, creditors, and governments (which must be prepared to act “in the last resort” when the entire financial system is threatened).

Bolingbroke is describing the proper British strategy in response to the danger that a single great power should dominate the European continent, and he sets forth what would today be termed by political scientists “an offshore balancing strategy.” Bolingbroke says: Britain should look upon “the powers of the continent, to whom we incline, like the two first lines, the principes and hastati of a Roman army: and on ourselves like the triarii, that are not to charge with these legions on every occasion but to be ready for the conflict whenever . . . necessary.” Never commit the whole, says Mr. B, unless the whole is at stake (pp. 56-57).

The shareholders are the principes, the creditors and bondholders the hastati, and the government’s lender of last resort function is the triarii. The idea is to let the first two lines bear the brunt of the fighting in the first and second instances, carefully husbanding one’s strategic reserve.

My view is that Paulson and Bernanke committed the triarii way too early, when the general equity averages were only down 20%. Probably this stemmed from their misunderstanding of the situation as a liquidity rather than solvency crisis. They also seemed to be unaware that there was a relevant ordering among different stakeholders—that is, they failed to distinguish adequately among the principes, the hastati, and the triarii in their generalship. Quite apart from various tactical blunders and obnoxious threats, the strategic concept was unsound.

It is interesting to think about the “last resort” function across a variety of fields. It is important not only in central banking but also (as with Bolingbroke) in military strategy. The concept plays an important role in theories of the just war. Someone could do a dissertation comparing the last resort function across these various domains. That would make a good book. Good luck finding a job!


11/01/08

Poor Goldman Sachs

It’s kind of ticking me off that Goldman Sachs received only $10 billion of taxpayer money in Paulson’s latest “plan.” The firm is severely undercapitalized and needs help. Its greater need for equity infusion as against other less deserving companies is clearly shown in the following charts.

Over the last decade, Goldman Sachs is up only 120% as against the S&P 500 Large-Cap Index. Poor Goldman Sachs.

The chart below is also pretty ridiculous in showing that Goldman has outperformed the Dow Jones Industrial Average by only 100%. The Dow is so old economy, filled with clunkers like GM.

GS's advantage over the tech-heavy Nasdaq-100 has been pared back from the glorious 275% advantage of a few years back, but we're still bullish. Tech doesn't really contribute much to the economy. Here's hoping that we can hold the early 2006 breakout at about 150%.

Coincidentally, our hero sprang into action on the day, September 18, 2008, that his old firm threatened to break below the long term Goldman Sachs: Russell 2000 ratio. Not gonna happen.

The following chart shows Goldman powering ahead of the Wilderhill Clean Energy Index. It confirms, of course, Efficient Market Theory. Previously I had been skeptical of that idea. Now I'm a believer. Taxmoney should go into the superior business model, as demonstrated by the record of the investment banks. That way, we can compete in the world economy. Alternative energy is for hippies. Let the market decide.

In conclusion:

In a world of uncertain values, we need a new standard of value. So to hell with the gold standard and the Dow:gold ratio favored by bears. Gold is a barbarous relic. Until January 20, 2009, at least, the coin of the realm is the Goldman standard.

10/26/08

The Grand Alternative

From The Oil Drum:

"Rather than spending a trillion dollars on buying toxic derivatives, or on a war, these funds would be better spent in helping private enterprise jump-start the above referenced conservation techniques and alternate energy research and implementation. The use of our hard-earned tax dollars to help accelerate these initiatives would create jobs and new businesses. The bottom-line is that solving the energy problem - which must be dealt with anyway, and soon - is the perfect solution to solving the consumption- and credit-induced economic dislocation we are now beginning to experience. There would be a third, important benefit. Energy conservation, increased natural gas use and alternate energy implementation all help lower CO2 emissions."

One of these days I will track down that link, but this passage gets to the core of the issue. 1 or 2$ trillion here cannot be $1 or $2 trillion there. There has been little discussion of opportunity costs in discussion of the financial bailout, but it pretty obviously forecloses just about every other policy initiative one might fancy.

London Banker eloquently summarizes what is at stake:

"If the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years, then no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes. Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation."

10/27/08

The US Hedge Fund and the Bond Conundrum

The mother of all bailouts has yielded a strange progeny: the United States as a Giant Hedge Fund.

Think back to the chart earlier showing the blowout of high yield bonds and credit spreads.

Note that the toxic paper the US government has taken on trades at an even deeper spread than junk bonds.

Note also that the public has an insatiable appetite for short term Treasury bills, whose yields have practically disappeared in the “flight to safety.”

Note in the chart above, finally, that investors have also rushed to the apparent safety of long term government bonds, which offer interest rates from 3.5 to 4.0 percent.

The bond conundrum, circa 2008, is simply this: How can the government take on all this bad debt without fatally impairing its own credit rating?

As investors have fled from all else besides government debt, the government has taken on the “all else.” Its guarantee makes its own debt equivalent in value to the debt it has taken on, does it not? That strongly suggests that long term government borrowing rates are going up. Every other asset class has crashed; why not government bonds?

Take up the debate over bonds--the eternal conundrum between inflation and deflation--in rival statements by Mish and Gregor. 10/26/08

Consider also another aspect of the bond conundrum, vividly portrayed by Jake at econopic in this chart of the total return of government bonds (including agencies) as against investment grade debt over the last 30 years:

The annotations are from Jesse.

11/19/08

Uncle Sam's Adjustable Rate Mortgage

I begin to re-think the “US as Giant Hedge Fund.” Hedge funds are in the business of making money, whereas the Treasury, despite its protestations, surely knows it is going to lose money. So thus far the hedge fund analogy fails.

Here’s a better one: Paulson and Bernanke are just like a freshly married couple about to buy a home in California in 2005. Sure, it costs $650K, and they only make $75K between them, but the initial payments are modest and the house will surely appreciate. Here's the deal: they pay only 1.6% on their "2-28 mortgage," meaning that the mortgage will reset in two years at a rate just above LIBOR.

This transaction, which the California couple is now greatly regretting, is the perfect picture of what the US government now proposes to do. With short term rates near zero, it has a cheap source of financing for its debt; the flight to safety has given it the opportunity to take out an adjustable rate mortgage with a super-low teaser rate. As of September 30, 2008, the rate on its short-term bills was only 1.6%, well below levels (4.7%) of a year before.

The problem is this: if average interest rates on government debt go up, as I think it very likely they will, the government’s debt will “reset” to a higher level—just like that now underwater couple that is faced in 2008 with much higher reset mortgage costs to pay down the debt on a depreciating asset. Notes Mr. Mortgage: "The same household that earns $75k per year that two years ago could buy a $650k home with no money down can now buy a $275k home with 10% down. It now takes at least $150k a year and a large down payment to buy a $650k home."

The following chart of mortgage resets, on the happy analogy of our California couple, suggests something of what is in store for the US government's debt over the next several years. (There is more on the government's debt structure here.)




"Hair of the dog that bit you" is indeed, as Jim Grant says, "the unifying theme" of the government’s response to the insolvency of our financial institutions. It's Alt-A all the way.

10/23/08
Updated 11/25/08

Twin Towers

When Lehman Brothers and American International Group collapsed in mid-September 2008, it was like the fall of the twin towers seven years before. Symbols of American financial prowess had crumbled to dust, betokening a world shaken to its very foundation.

Important as the crisis is in its own right, it is the response of the government—its way of molding into stone in ten days measures that will have consequences for ten years—to which I draw attention. After 9/11/01, the mind of the Bush administration was made up quickly. They were going to war, first with Afghanistan, then with Iraq. Public discussion of alternatives, and criticism of the administration, was virtually non-existent in the mainstream media. Most Americans have reconsidered the Iraq War and think it was a big mistake. But we’re still there.

The mood now is different, but there is the same essential dynamic, in which great crisis produces the demand that something be done immediately, foreclosing the opportunity for deliberation. It follows inexorably that the executive must be entrusted with the details, because circumstances change and confidentialities must be preserved. Voila! There you have your ill-considered, secret, untransparent decisions, made in a rush, entailed upon the subsequent generation. The collective response is something like: We Need to Act! No Time to Think!

This is hardly the model of republican deliberation for which American political institutions were once renowned. It is very unbecoming to a polity that purports to respect constitutional values.

The phenomenon is probably best seen as a rather grotesque form of “path-dependency,” that is, the idea that where you end up depends on where you start. Paul Krugman got a Nobel Prize for his variations on that proposition, demonstrating that for some industries small initial advantages can make a big difference. But Krugman was thinking about how industries achieved a competitive edge. The concept of path-dependency is equally relevant to how polities reach dysfunctional decisions. The September/October 2008 decisions of the US Treasury and Federal Reserve will cast a very long shadow.

Chalk up another cause for depression.

10/26/08