Friday, March 21, 2008

What's going on?

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:
The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.
That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

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8 Comments:

Anonymous Anonymous said...

It's happening because of a loss of trust. US banks, shadow banks, ratings agencies, etc... tried to pass bad paper off onto the market (knowingly or unknowingly), and the market no longer trusts their products. They want out, all the way out.

Sat Mar 22, 05:38:00 AM EDT  
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Mon Apr 20, 10:31:00 PM EDT  
Anonymous Anonymous said...

What we have seen during the past few years happen to the American banking system is nothing new in US hitory. Banking in the United States has always oscilliated between conservatism and extreme risk-taking, usually with the same results with either the federal government or a few very rich men bailing out a bank or the entire system ( see Economic Panics of 1837 and 1873).

In reality, the federal government cannot stand-by and watch banks fail. If this hands off approach would have been the scenario in 2008 the United States would have has a financial system that resembled the one it had at its' inception in 1786.

The purpose is to keep a banking system - all of which are fragile -from being overwhelmed and placed in the trash bin of history. It is imperative that some form of credit-lending is kept above the water-line of insolvency and civilization destroying meltdowns. That is what most people forget who critize the latest chapter in financial bailout of banks forget: Money is the mothers' milk of the US economy and the banking/financial system is the life support system of the America.

Danny L. McDaniel
Lafayette, Indiana

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