What if no bailout happens?

[Beth]

I'm not smart about money and high finance. What is everyone so afraid will happen if the government doesn't bailout the wall street firms? Why is the bailout a better option than letting them figure out their own way out of the mess? Why is it a better option for our government than, say, financing public works projects to make sure that there are plenty of jobs for people who are willing to work and financing social security for those who are unable to work?

 

[Delvo]

Why, then everything would collapse! COLLAPSE, I tell you! It would all just &#$@% COOOOOLLLLLLLAAAAAPSSSE!

 

[Francesca R]

They're afraid that a generalised collapse of the ability to borrow and lend money will happen, which will stop non-financial companies from being able to run their businesses, and that the large fall in wealth and the value of savings (perhaps augmented by bank runs) might produce a catastrophic drop in demand on main-street World.

If that belief, or something approximating it, was correct--then the average taxpayer would face lower taxes, and higher living standards over the long run if the government utilises taxpayer-funded bailouts than if the government permitted the collapse of the financial system under the doctrine of a "bailouts are bad" principle. So it would be justified on utilitarian social welfare grounds.

In all honestly, nobody knows exactly what will or would happen and it is probably impossible to take a strong position on this, and one who does probably does not know what they are talking about. And there are moral hazards involved. [In fact--there is a view that the Fed/Treasury in the US has been too keen to avoid moral hazard and have punished shareholders (of Fannie, Freddie, Lehmans and AIG) excessively, with the result that "everybody knows that equity holders will lose everything", so the panic selling is accordingly fuelled.]

 

[drkitten]

I'm not smart about money and high finance. What is everyone so afraid will happen if the government doesn't bailout the wall street firms? Why is the bailout a better option than letting them figure out their own way out of the mess? Why is it a better option for our government than, say, financing public works projects to make sure that there are plenty of jobs for people who are willing to work and financing social security for those who are unable to work?

Simple answer : because if the banks collapse, credit will no longer be available, since most of the credit is backed by reserves held in investments. Heck, deposits will no longer be available as the money supply collapses, since those reserves are what your deposits have gone into.

How much actual cash do you use in your daily life? Not debit cards, not credit cards, not checks, but actual folding money? Because if the banks' investments truly tank, that will be what you're operating with.

 

[Beth]

Simple answer : because if the banks collapse, credit will no longer be available, since most of the credit is backed by reserves held in investments. Heck, deposits will no longer be available as the money supply collapses, since those reserves are what your deposits have gone into.

How much actual cash do you use in your daily life? Not debit cards, not credit cards, not checks, but actual folding money? Because if the banks' investments truly tank, that will be what you're operating with.

You're saying that if the government doesn't bail out wall street, my credit union debit card will no longer be any use to me? I honestly don't get the connection.

 

[Beth]

They're afraid that a generalised collapse of the ability to borrow and lend money will happen, which will stop non-financial companies from being able to run their businesses, and that the large fall in wealth and the value of savings (perhaps augmented by bank runs) might produce a catastrophic drop in demand on main-street World.

Okay. I'm don't understand why they think this would result. Just like I don't understand why drkitten thinks that debit cards and checks would no longer be useful. What's the connection between wall street financial companies and my local credit union?

 

[drkitten]

You're saying that if the government doesn't bail out wall street, my credit union debit card will no longer be any use to me?

That's an admittedly extreme and probably over-the-top case.

But the connection is fairly simple. Banks, like every other business, are in it to make money; they make money from lending their depositors' resources out. If the credit system collapses, they will neither be able to make nor receive loans (more accurately, they will not have any rational expectation of repayment, so they will not make loans, and no one will be willing to extend them loans for the same reason.) At that point, they might as well shut up shop and return the deposits.

But they can't return the deposits because they're already lent out or invested. Without having your deposits as cash on hand, it may be forced to write them off as bad debts (or bad investments).

So where is your credit union going to find the money to pay the debit charges?

 

[Francesca R]

In short, banks, (and non-bank financial institutions like AIG too) are linked to the rest of the economy much more intimately than firms in other industries. You could think of them as the hubs of a spoke-and-wheel network of financial interconnections whose integrity is widely believed to be vital to the smooth operation of your local store, credit card company, gas station, butcher, baker and brewer too.

 

[Gurdur]

Okay. I'm don't understand why they think this would result. Just like I don't understand why drkitten thinks that debit cards and checks would no longer be useful. What's the connection between wall street financial companies and my local credit union?

One connection would be:
AIG insures loans made to banks, insurance covering credit made. So say if the loan insurers go down, your local credit union is extremely likely to be incredibly nervous about lending anyone cash at all -- including you.

 

[drkitten]

Okay. I'm don't understand why they think this would result. Just like I don't understand why drkitten thinks that debit cards and checks would no longer be useful. What's the connection between wall street financial companies and my local credit union?

The Wall Street financial companies are holding most of your local credit union's money, the stuff that makes the connection between their assets (the loans that they are due) and their liabilities (the deposits that are due YOU). This is generally a good thing because Wall Street pays much better than a cookie jar. But it means if the connection gets broken -- if the money they thought they had to pay day-by-day expenses vanishes -- then the bank will cease to operate, even though it's still got assets on hand.

 

[Beth]

That's an admittedly extreme and probably over-the-top case.

But the connection is fairly simple. Banks, like every other business, are in it to make money; they make money from lending their depositors' resources out. If the credit system collapses, they will neither be able to make nor receive loans (more accurately, they will not have any rational expectation of repayment, so they will not make loans, and no one will be willing to extend them loans for the same reason.) At that point, they might as well shut up shop and return the deposits.

But they can't return the deposits because they're already lent out or invested. Without having your deposits as cash on hand, it may be forced to write them off as bad debts (or bad investments).

This is the part I don't get. They'll still be receiving my deposits (with which to pay my debit and checking transactions) and they'll still be receiving my loan payments, including interest, so they would continue to be making money. Nor do I understand why they would write off my deposits as bad debts. That doesn't make sense to me. If they would be forced to write off their loans to the wall street firms as bad debts, it makes more sense to me to have the government bailout consist of paying off such debts to other institutions so that they don't, in turn, go bankrupt than to bailout the wall street firms so they can continue operating.

So where is your credit union going to find the money to pay the debit charges?

From my paycheck that gets deposited there just prior to my spending the money. I understand what you're saying. But I don't see why bailing out the wall street firms is a good solution to the problem. Why not bail out the banks and credit unions that have loaned their deposits to the wall street firms instead?

In short, banks, (and non-bank financial institutions like AIG too) are linked to the rest of the economy much more intimately than firms in other industries. You could think of them as the hubs of a spoke-and-wheel network of financial interconnections whose integrity is widely believed to be vital to the smooth operation of your local store, credit card company, gas station, butcher, baker and brewer too.

This makes some sense to me, but to continue with the wheel analogy, if the hub is disintegrating, perhaps it would be better to replace with a new carbon-fiber composite hub that will work better, last longer and cost less. Or perhaps it would be better to consider whether we need to continue with such an antiquated hub and spoke wheel system. A redesign might be a better course of action than trying to pick the pieces and continue on with the same old same old. Particularly when the cost of repairs is so high. So why is the bailout of these firms a good idea?

One connection would be:
AIG insures loans made to banks, insurance covering credit made. So say if the loan insurers go down, your local credit union is extremely likely to be incredibly nervous about lending anyone cash at all -- including you.

I actually kind of understood the reasons for the AIG bailout. It's this latest one that has me completely befuzzled.

The Wall Street financial companies are holding most of your local credit union's money, the stuff that makes the connection between their assets (the loans that they are due) and their liabilities (the deposits that are due YOU). This is generally a good thing because Wall Street pays much better than a cookie jar. But it means if the connection gets broken -- if the money they thought they had to pay day-by-day expenses vanishes -- then the bank will cease to operate, even though it's still got assets on hand.

Okay, banks all over the country have put their assets into these firms, and then draw on them when they need them. Why are we bailing out the wall street firms instead of the banks that were their customers?

 

[Francesca R]

This makes some sense to me, but to continue with the wheel analogy, if the hub is disintegrating, perhaps it would be better to replace with a new carbon-fiber composite hub that will work better, last longer and cost less. Or perhaps it would be better to consider whether we need to continue with such an antiquated hub and spoke wheel system. A redesign might be a better course of action than trying to pick the pieces and continue on with the same old same old. Particularly when the cost of repairs is so high. So why is the bailout of these firms a good idea?

Those metaphrorical ideas might be wise but they are not something that policymakers have the luxury to design and ececute at the moment where they think the vehicle is veering off a cliff.

 

[seayakin]

I don't know if hub and spoke metaphor is correct probably more like a lawn sprinkler system. Investors are the the aquifer which supplies water to the sprinkler system. Consumer banks and consumer investment firms are the hoses supplying the sprinklers which are the investment banks. Watering the business (grass) which use the money to maintain or increase operations by maintaining adequate cash flow. These businesses in turn pay workers (consumers) just as the water from the sprinklers might drip down to the aquifer recharging it.

Now if you cut back the flow in any area, the system reduces the growth of the grass. The Fed is trying to maintain this flow of water to ensure that business will not completely fail (grass die) which in my analogy would block the flow of water to consumers. This metaphor doesn't allow for the addition of new water but imagine that the grass somehow created new water that got pumped in the aquifer when it grew. Now if one sprinkler fails, some grass may die or a redundant sprinkler may keep that grass growing but if 90% of them fail then the lawn may die which means no water will eventually recharge the aquifer.

In the end, this is all about maintaining cash flow between consumers, banks and businesses that employee consumers.

 

[Beth]

Those metaphrorical ideas might be wise but they are not something that policymakers have the luxury to design and ececute at the moment where they think the vehicle is veering off a cliff.

Our economy is veering off a cliff? Everyone on the news talks like that too. How is it our economy is veering of the cliff just because stock prices are going down and investment firms going under? But it wasn't going off a cliff when mortgage foreclosures were going through the roof?

 

[Francesca R]

I don't know if it is veering off a cliff. That is the genuine *fear* of policymakers. and for "why", this is going in cirles: because the financial payments system is at the centre of almost all economic activity in the developed world, and mortgage foreclosures, at the rate they are occuring, are not.

 

[seayakin]

The real question is:

Was the risk to the economy so severe that it is worth taxpayers accepting the risk for the bad loans these companies made and/or purchased?

For instance, if 90% of the lending and investing that these banks ended tomorrow due to insolvency, this would halt the flow of cash to successful businesses that go to these banks for ongoing operations. Businesses like Walmart do not actually buy all that inventory that sits in their stores, they borrow money from an investment bank or other source to pay for that much of that inventory and pay it back when they sell it. (Walmart also beats up its suppliers so they take the risk of borrowing and not Walmart.) If that money becomes unavailable, Walmart either fails or it has to buy its inventory with cash on hand which slows the turn over of merchandise reducing its income and reducing the size of its business which hurts its workers.

However, the question no one can answer is, if we let all these investment bankers fail, how broad would the impact be? And, if it is a wide impact, are we better off letting them fail to insure investment bankers do due dilligence on their loan portfolios so they are not putting our money in junk that will never see a payoff instead of the taxpayers accepting the loan risk for all these junk investments.

 

[Tippit]

I'm not smart about money and high finance. What is everyone so afraid will happen if the government doesn't bailout the wall street firms? Why is the bailout a better option than letting them figure out their own way out of the mess? Why is it a better option for our government than, say, financing public works projects to make sure that there are plenty of jobs for people who are willing to work and financing social security for those who are unable to work?

If bank bailouts don't happen, then due to fractional reserve banking they will become insolvent, and their depositors and counter-parties will also become insolvent. This means the "savings" of people like you will vanish into thin-air, like what happened in the great depression. Now, you may be wondering how all of this could happen with FDIC, however, FDIC only has roughly $45B in funding to cover $1T (or possibly much more) in at-risk deposits. The men behind the curtain have decided to bail out the banks before bailing out FDIC, as presumably this would be less catastrophic.

Of course, the real question that isn't being answered, at least by the media or other pundits, is how did we get into this mess in the first place? The answer, of course, is that it was inevitable given the system. We have a system of endless inflation and monetization of debt, coupled with fractional reserve banking, which is inherently unstable. No one typically complains during the boom phase, when money is cheap and prosperity in the form of ever-rising real estate prices seems limitless. But like every great party, the hangover can be brutal. It will take years to reconcile all of the mismanagement and malinvestment that has occurred due to the Federal Reserve, and it will be painful.

 

[seayakin]

Of course, the real question that isn't being answered, at least by the media or other pundits, is how did we get into this mess in the first place? The answer, of course, is that it was inevitable given the system. We have a system of endless inflation and monetization of debt, coupled with fractional reserve banking, which is inherently unstable. No one typically complains during the boom phase, when money is cheap and prosperity in the form of ever-rising real estate prices seems limitless. But like every great party, the hangover can be brutal. It will take years to reconcile all of the mismanagement and malinvestment that has occurred due to the Federal Reserve, and it will be painful.

I haven't thought much about the issues of fractional reserve banking. Are you thinking we should not have this or that the deposits required by the regulators are too small?

 

[Tippit]

I haven't thought much about the issues of fractional reserve banking. Are you thinking we should not have this or that the deposits required by the regulators are too small?

I am a proponent of the abolition of central banks, sound money, and 100% reserve banking on demand (non-time) deposits. This would serve to eliminate the business (boom-bust) cycle, enable free market interest rates, and enable steady, sustainable economic growth without monetary policy arbitrarily benefiting bankers, real estate owners, or any other special interest.

This of course is antithetical to the massive corporate welfare that is occurring right now, and it's not likely to be a subject you will see brought up by the media anytime soon. It is however, perhaps the most important subject that intelligent people can reflect upon.

 

[martu]

I am a proponent of the abolition of central banks, sound money, and 100% reserve banking on demand (non-time) deposits. This would serve to eliminate the business (boom-bust) cycle, enable free market interest rates, and enable steady, sustainable economic growth without monetary policy arbitrarily benefiting bankers, real estate owners, or any other special interest.

Care to elaborate on this? I don't see the connection I must be missing something.