DodecaPentafoil Tangle by Carlo H. Séquin

Fed and Treasury officials have identified the disease. It’s called deleveraging, or the unwinding of debt.

There’s an excellent article at the Wall Street Journal which I recommend you take a look at to make some sort of sense of what’s going on with the financial system. The article explores the nature of the crisis, its history, and prospective remedies. The quote that starts the post is taken from the article. Rather than excerpt the article I’m going to ask a few questions that the article brought to mind for me.

What would the implications be of the bondholders taking the losses for what’s going on? The shareholders? The government?

By “bondholders” i mean, essentially, the customers and by “shareholders” I mean the companies. It seems to me that these are the critical questions for those who favor a “Resolution Trust Corporation” approach analogous to the one used for coping with the S&L crisis of 25 years ago. The financial instruments that comprise most of the assets involved are very complex and difficult to value. Indeed, part of the problem is that the people who devised them were unable to value them. Without government intervention if these assets are written down to zero, the shareholders take all of the pain. If they’re valued at face value, the bondholders take the pain. If the government steps in the taxpayers take the pain, moreso if the government values these dohickies wrong.

Justice might suggest that some formula be found whereby bondholders and shareholders share the pain, i.e. let the market prevail. The problem I see in that approach is that the sums are so titanic and spread so broadly that it’s rather difficult to see what the consequences of that might be. Governments could fall. We just don’t know.

Additionally, to what degree are the shareholders actually pension funds? The government may well be placed in a situation of dealing with it now or deal with it later.

Why hasn’t the financial crisis been translated into the rest of the economy?

There’s an old story about three Hasidic businessmen who are shipwrecked on a desert island and become fantastically wealthy by trading each others’ hats. The only thing they have to worry about is being rescued. I can’t help but wonder if the financial system isn’t in the process of being rescued from the binge it’s been on for the last 25 years in which values of equities have become completely unmoored from the underlying businesses (and analogous situations in real estate, commodities, and so on).

Is it just a matter of time? Is it localized so that some places are feeling all of the pain while other places go scot-free? Are the explanations of the article, i.e. that the government has acted aggressively, that exports are strong, and that the economy is resilient, correct? If the economy is so resilient that a meltdown in the financial system has virtually no impact on the remainder of the economy is there any reason for the government to act at all?

What sort of action would be the correct kind?

As I suggested in my previous post this morning, I can’t help but feel that today’s regulation mechanisms, not just the regulations but the mechanisms themselves, aren’t equal to the problems posed by today’s financial system. Is any action better than no action? Why would this be true other than to force innocent bystander taxpayers to share the pain being felt by bondholders and shareholders? Which way does the politics on this cut? It’s hard for me to see the electorate mustering a lot of sympathy for the top management of the financial firms.

The picture above is DodecaPentafoil Tangle by Carlo H. Séquin. You can click on the graphic for a larger image.

2 comments… add one
  • PD Shaw Link

    I liked the Wall Street Journal article, but it skipped my first question regarding a Resolution Trust model. What is or did the government insure? IIRC the government got involved in the S&L crisis because the government insured deposits in S&Ls and then the S&Ls failed; the government was forced to make good on the deposits and then it formed the Resolution Trust to liquidate all the assets of the defunct S&Ls.

  • That’s right, PD. The problems with an RTC-like scenario for the present crisis are many but as I see it the most significant are

    1) the sheer size of the problem;
    2) its global nature;
    3) evaluating the assets of the institutions.

    There’s no obligation to do any of this but that leads to the question of how any administration could fail to act under the present circumstances. I don’t think it would be politically possible.

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