Recapitalizing the Banks but Decapitating the Economy

0:00I just want to, before we get into the meat of this, because it is sort of a depressing topic, as opposed to, I'm sure you have other speakers make light of decapitation, but we're going to do it the serious way here. Jeff was mentioning when he was up here that the Mises Academy, he said, it's like having Bob Murphy over for dinner, you really can't tell the difference. Well, I've been to Jeff's house for dinner, I can tell the difference over my computer screen. It really, you kind of know the difference. The other thing that it's, it might just be my personality or whatever, I like to worry about things, but it's, you know, Jeff was up here, like, just very enthusiastic, as Jeff always is talking about, you know, when these ideas, these things that are free, that, you know, they're immortal, you know, once you say this idea, it gets out there and you can't pull it back, you know, and people hundreds of years will know what it was that you wrote

0:50down. And I'm here thinking, I'm kind of afraid to write more articles now. One other sort of light thing before we really get into the meat of this is, and this is not a joke, this really did happen, it was a few hours ago, Jeff was mentioning his daughter, I was, before the conference started, before I had to go get something to eat and I came out of the Auburn Hotel and I'm driving down, I forget what street that is, over here, coming and I was going to turn right at the Tumors, those four corners, that real busy intersection, I'm in the right lane, and I'm coming up to the crosswalk, and it's a red light. So I'm slowing down. But you know how you edge forward, and then you look, and then you turn. But there was a big truck that was in the left lane, right up on the crosswalk.

1:38And I'm driving along, and I thought, you know, I'm going to slow down, because it's possible there's a pedestrian that's right in front of that truck that's going to step out. And so I did. And it was fortunate, because a young lady did step out, and it was Julia Tucker. So besides just, you know, that I would have felt bad if I hit somebody, I was thinking that probably would be a really awful career move if on the day of the supporters' summit I hit Jeff's daughter right before we were both supposed to speak. So fortunately, let that be a lesson for all of us. Okay, so I'm a little bit squeamish about talking about this topic. It's very important. The problem is that, you know, when you're teaching a bunch of students, young people, You can say whatever you want because they don't know, right?

2:24Whereas I'm always a little hesitant of these supporters, because a lot of you actually, first of all you're adults most of you, and so that's one strike against me if I'm bluffing, but also many of you have money so you actually understand how the world works, and so I have to be careful if I'm going to start talking about banking and accounting and things like that. So hopefully if I make any mistakes you guys will at least correct me once I'm off camera. So let me see now, I have to actually show you some slides. Now this is actually, for those of you who have seen my lectures, usually I don't use things, I just sort of get up and wing it, but just as a token of my appreciation for the donors here, I actually did some research before, I'm going to give this talk, so I'm going to show you, you should feel special.

3:10What I'm going to do is show you a few slides, not going to be too many, I don't want to I don't want to overwhelm you, but the points I want to make, if I just hold you in words, you wouldn't really get it. I mean, some of these graphs are really just shocking. So before I get into this, let me just set the context. There's a little bit that you need to know. Again, some of you in the crowd here, probably this is going to be really elementary to you. But again, just in dealing with the crisis and so forth and seeing the pundits talk about it, it became clear to me that a lot of people, So, they don't understand just real basic accounting things and people that are on CNBC even just spouting stuff, they don't even know what they're talking about. And it's, how can I put it, I think you people would be, if you really understood how the mainstream economists and the pundits, how little they knew what they were talking about, you'd be horrified.

4:04Okay, now, I think you're probably saying, oh, come on, we know those guys, but you don't because they use jargon. And so you're not really sure what they're saying. Like, you know they're wrong and that their conclusions are stupid, but you don't really get what they're talking about, right? But whereas I've got a PhD, I know what they're saying, and I'm just like, this guy has no idea what he is talking about, all right? So let me just try to get that across to you. One thing, again, it's also for people who are watching online and they need to know some of this background, Let me just very quickly go over the distinction between a firm that takes on more debt versus more equity because that's related to a lot of the discussion of how do we fix the economy. It happened before the crisis really kicked in in September of 2008.

4:51People were talking about a credit crunch before that and so forth, but that's when it really came to the fore. The issue was a lot of economists and pundits, they were saying, man, I can't understand. The Fed's been cutting rates, they're having all these, you know, opening up liquidity facilities and so forth, and the banks aren't lending. What's going on? It doesn't make any sense. It's like we're pushing on a string, like, you know, the Keynesians used to talk, what's going on? And so a lot of people, economists and other analysts who were actually involved in banking that weren't just, you know, some macro person that did a lot of blackboard diagrams and was asked to comment on this crisis because, well, gee, the person who teaches economics at MIT, he must know what he's talking about. But the people actually involved in the financial sector were saying, well no, this isn't a liquidity crisis, it's a capital crisis. You know, the banks are not liquidity constrained, they're facing capital constraints.

5:39And so it's, just to give people a little hint as to that distinction, what are we talking about, just imagine you're somebody, you have $5,000 in cash, let's say, that you've saved up, and you see this investment opportunity, You see some asset out there that costs $10,000, and you think, if I buy that, I bet you that thing is going to go way up in price over the next 12 months. I really want to buy that thing, but I only have $5,000, it costs $10,000. So there's two things you can do. You can go borrow $5,000 from somebody, so you're going into debt, to buy that thing. What happens there? Well, you buy it, if it does go up in price, and then you sell it, you actually, you can obviously pay the debt off, and in a sense you've doubled your return, the rate of return, as opposed to if you had that 10,000 yourself and bought it, right?

6:33Because you only put up 5,000 of your own money, so in terms of the ultimate jump in asset price compared to your smaller investment, the rate of return is higher. But the downside of doing that, of course, is that if you're wrong, you borrow $5,000, you buy this thing and it goes down, well then that in a sense doubles your loss, right, because you have to pay that person off according to the terms of the loan, and so in a sense it magnifies how much that loss hits you, okay? And so in contrast, you could say, instead of borrowing the money, you could go find someone and say, hey, do you want to be my partner on this? So we'll go in 50-50, you chip in your $5,000, I'll chip in my $5,000, we'll buy this thing that costs 10, and if it goes up $1,000, then we sell it and you and I each get $500 profit.

7:24So what happens there is you're diluting your ownership in that asset, and in a sense you're spreading out the risk that you're now, if it goes up, you only keep half of the gain, The Pro of doing that is that if the thing goes down, then you're only eating half the loss, because you're sharing with your business partner. Again, this is really basic stuff to most of you in here, but that's why the banking system, if you have a bank that's in trouble, and the mere fact that the Federal Reserve, for example, is standing in the sideline saying, hey, I'll lend to you basically at zero. is you know so here you go in that bank still might say no I don't I don't want to even if there's something out there that looks like it might be a good investment you know that it would have a rate of a positive rate of return if the bank is on the verge of bankruptcy already then it might be just afraid to

8:21borrow and do that all right so that's why if you think back when TARP was originally proposed that again what was the was that acronym it was the Troubled Asset Relief Program. So originally, when Henry Paulson, who was Bush's Treasury Secretary, when he proposed that, the idea was he needed $700 billion and he was going to just directly buy those assets off of the banks, and people were making jokes back then saying... The idea was, because you say, well, why is that a good deal for the Treasury? Why would they pay more for these mortgage-backed securities that the investment banks and other institutions are holding than the market wants to pay for them, isn't the taxpayer just eating the loss?

9:07And the Treasury's official position was, no, no, no, see, it's not that these things are really that awful, it's just there's this systemic panic going on, everybody, you know, there's fire sale prices, it's by us coming in and buying up these things, we'll restore confidence and it'll be a self-fulfilling prophecy and then, you know, the assets will And so a lot of bloggers were making the joke saying that Paulson's position was that there was no such thing as a bad asset, just a misunderstood one. But, of course, that's not what happened. It's not that the U.S. Treasury acquired $700 billion of mortgage-backed securities. Instead, what happened is Paulson, if you remember, this was late September of 2008, and then I think that's when the first vote went. The first vote went, and it didn't go through, because the people in Congress were literally getting calls, I heard at various estimates, but nine to one against, if not more.

10:00Their constituents calling and saying, no, you do not take $700 billion in bailout investment bankers. That's crazy, right? And so being, as we do live in a representative democracy, at first, it took like three days for Congress to ignore the constituents. So I mean, it's, thank goodness we don't live under Saddam Hussein or some crazy autocrat. So, that's what happened, but the moment, I don't remember the exact timing, but it was within a week, I think, of when he got the authorization. He said, actually, I talked with my advisors and what we just said, that would be stupid if we bought these assets, because how would we know how much to pay for them? If we didn't pay enough, that wouldn't be helping the banks, right? Because they're all insolvent right now with these assets on their books at current market prices.

10:45So, right now, if a hedge fund would be willing to offer them 15 cents on the dollar and that would make them insolvent, that's the problem. If we come along and offer them 16 cents on the dollar, that doesn't really help. But to really help them, if we give them 95, 96 cents on the dollar, well then, obviously, the taxpayer might take a huge hit and that's bad too. So, second thought, that's a dumb plan. But, since you already gave me the $700 billion, here's what I'm going to do. We're going to buy ownership claims in a lot of these banks, and that's what he did, but they still kept calling it TARP even though it was no longer the Troubled Asset Relief Program, it was the Socialized Financial Sector Program, but that wouldn't make a nice acronym, so that's what he did, but it was true that the objection to the original TARP plan as it was originally conceived was perfectly valid.

11:40was going on there, and there were a lot of people that were saying it all along, and not just free market people, but even to his credit, people like Paul Krugman were saying this plan is stupid, what you need to do is recapitalize the banks, that's the only way you're going to fix this just by swapping some of their assets around, that's not going to fix the problem that their capital has been eroded, and that they're not going to lend. Okay, so that was the alleged purpose of TARP, was to recapitalize the banks so that they'd be willing to lend again. I mean, I think we can all remember all the rationals that people say, yes, yes, you know, we can't stand the fact that we have to bail out the biggest contributors to our campaigns. It just causes us physical pain. We don't like helping big corporations any more than you guys do, but we have to do this.

12:27We have to hold our nose and bail them out because the financial system is the lifeblood of our economy. and they kept talking about small businesses. Small businesses can't get loans, they can't make their payroll. And at the time, I was suspicious. I would go around and ask small business people and say, do you have to borrow money to make your monthly payroll? And they were like, no, I'd be in trouble if I had to do that. That'd be crazy, right? So anyway, I almost thought that maybe the people in the government were lying, but I don't want to go that far. So he's doing this stuff. And so that was the rationale, right? And And remember, even up until then, the whole mantra was that we had this credit crunch. That was the deal. And now, of course, if you just was in mid-September, when the head of the TARP program was stepping down and Timothy Geithner was like in the going away party or whatever, was congratulating

13:19this guy and like talking to the team and the speech is actually really funny. You can get the text of it at the Treasury website about Geithner basically, you know, Hey guys, you know, no one appreciates what you do, but I do, and that kind of stuff. And there, I mean, his words were very carefully chosen, because he didn't say we actually restored lending to small businesses and things like that, or that businesses now can get... All he said was things like, you know, credit spreads have shrunk and interest rates have... Businesses can now borrow on better terms. So he was referring to interest rates and things like that. He didn't actually talk about the volume of loans because the actual data is the exact opposite of what you would think. So if you just listened to the news commentaries, you watched CNBC, you would think that loans from the commercial banking system to businesses had been falling pretty precipitously up until TARP kicked in and then you would think it turned around.

14:18Let me just show you the actual chart. It's not quite that.

14:31I don't know if you can see that in the back, but I'll read the top. It says commercial and industrial loans at all commercial banks. So you can see it went up, up, up, up, and it peaked and then came down. Now, you know what month it peaked in? October of 2008. That was the month that TARP started. Okay, so just to put it in words, commercial and industrial loans from commercial banks were at an all-time high in U.S. history right when TARP kicked in and then they fell off a cliff. Now, I have brought that up to people. The one time I was on Larry Kudlow's show and I brought this up and everyone else was just laughing at me like I was an idiot and Well, they said counterfactual, and they moved on. What they meant was, it would have fallen off even more steeply had TARP not kicked in, which maybe it would have, maybe it wouldn't, and we don't know.

15:23But my point is just, you would have no idea that that's what the chart looked like, and the people are patting themselves on the back saying, it's a good thing we invested $700 billion right at the peak of that, otherwise loans to businesses might have fallen off the cliff. Just to show you something else that's kind of funny, to the extent that anything from the St. Louis Fed can be funny. This chart shows consumer individual loans at all commercial banks. So the top one was just showing loans to businesses. This is commercial bank loans to individuals, and you might say, oh, well, that's interesting. So it also, notice, starts falling, it looks like a few months after TARP kicked in, right? in late 2008. But then, in early 2010, it zooms way up. You're like, whoa, that's weird.

16:12What's going on there? It must be the banks all of a sudden made a bunch of loans. No, what happened there was there was a rule change and they had to include, I think it was all credit card debt, which previously hadn't been these numbers. So just one thing that coincidentally made it look like now the banks were lending more. So if you see, once you Adjust for that shift upward, that too, you know, it still is trickling down, okay? So again, whether you're looking at loans to businesses or individuals, basically once tarp kicked in, they've been steadily declining. So why is that? Well, it goes back to what I was talking about before, and Doug's talk, he listed a bunch The banks have been suffering huge losses on their other loans.

17:02In terms of accounting, you've got your liabilities on one side and your assets and your equity on the other. If you're writing down the value of your assets because you're sitting on a mortgage or mortgage-backed security and the homeowners are defaulting, then obviously you've got to write down the value of your assets that erodes your equity, the amount of capital you have. Just because you have the Fed willing to lend you money at 0% or what have you, it doesn't mean you're eager to go out and lend. So the banks are basically just hunkered down waiting for these write-downs to stop. And just to give you an idea of the magnitude, again, Doug read you some statistics, but this chart might make it more vivid for you. So what this is, those in the back who can't see the text, this is net loan loss is divided by the Average of Total Loans, and so you can see there, so that it goes back, the chart

18:00starts in 1985, or maybe 84, and you can see that in terms of the percentage of their total portfolio and the losses they're taking, that it's much higher this time around than, you know, in the earlier crises as well. I don't know if it had gone back to 81 and 82, what that percentage would have been, but you can see how this isn't just, oh yeah, we hit a recession, I mean this is huge. So this again partly explains why the banks are not eager to make more loans when their balance sheets are getting wrecked by these write-downs. Okay, now this, don't worry, I've just got one more chart after this one and then we'll go back to funny jokes about hitting people with cars. So this, this is, there's two things going on here. So the, I want you to first focus on this line right here, the one that goes up.

18:50what that is US government securities at all commercial banks okay so that's showing the market value of I think it includes treasuries you know bonds issued by Uncle Sam as well as bonds issued by the GSC government-sponsored entities Fannie and Freddie because now that's classified in this thing as government debt because the government's backing it up all right so what you see The key here is that was pretty much constant throughout the main housing bubble years and then about when all these rescue actions kicked in, you see it goes up by about what? About $400 and so billion dollars, meaning the commercial banks added to their balance sheets $400 plus billion dollars of debt either from Uncle Sam or the GSEs, which is implicitly the same thing now because the government's guaranteeing all that stuff okay so it's it's not actually and just in the other line here is just showing what happens to interest rates okay that so you see once interest rates come down that's when this happened so to try to understand what's going on

20:05there part of it is that when the Fed pushes down interest rates so you can't earn interest anywhere else what do the banks do they go buy what are very safe of Money, the Federal Reserve, the Federal Reserve, the Federal Reserve, the Federal Reserve,

20:45This is the last chart we'll show. This is Excess Reserves of Depository Institute. Now it's almost hard for you to see it because it hugs the zero line for most of history and then, boom, jumps up by $1100 billion or $1.1 trillion. So this refers to the fact that the Fed came in in late 2008, especially, but then also a little bit afterward, and just doubled its balance sheet, more than doubled its balance sheet, just started buying assets like crazy, mortgage-backed securities in particular, bailing out the banks, okay, and that's partly why TARP made money, is because the US government bought shares in banks and then the Federal Reserve came in, created a trillion dollars out of thin air and bought a bunch of the assets that those banks held.

21:39So that's a nice way to make money if you can do that. Insider trading is one thing, having a printing press is another. So it's a neat trick. So you see, those excess reserves are sitting there. The banks are not lending them out. And so that's partly why you haven't seen gasoline prices go up and milk prices go up and so forth, even though you would think, well, gee, if the Fed creates a trillion dollars, shouldn't that cause a bunch of price inflation?

22:37The Federal Reserve is basically buying all the debt that Uncle Sam is creating. But if you ask the regular financial public, they say, no, they're not doing that. The markets would freak out if they're doing that. Bernanke is very responsible. They say, no, it's, yes, the Fed has bought some of it through their quantitative easing back in 2009, but most of this new debt is being picked up in people in the private sector

23:36that long-term yields on U.S. debt, U.S. government debt, are relatively low, even though Obama's spending money like crazy and borrowing money like crazy, and why do we see gold prices hitting all-time highs? It seems that people talk about the bond market being schizophrenic, but not if it's really the Fed is the one buying all this stuff, right? So it's not surprising that you can keep down yields, at least temporarily, if you just keep creating money and buying those things, those bonds, right? The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

24:36Earning that income in the overtime, they're willing to sit there for years, just slowly earning income and working off those bad loans that they made. But it's bad for the economy for several reasons, just a few of them. Those low interest rates, well, this is the exact strategy that Greenspan did when the dot com bubble burst, right? Back then, back when people were calling him the maestro, you might remember, he lowered interest rates to give the US economy a soft landing after the dot com bubble burst. And people called him the maestro because, man, home prices didn't fall during that recession. They kept rising. That's great. Good job, Alan. And now, of course, not just Austrians but regular economists are saying, maybe that wasn't such a good idea. Maybe all he did was postpone the crisis and set the stage up for an even worse calamity that hit, you know, 2006, 2007, 2008. And yet those same people are saying, but now, of course, it would just be too awful if we faced this thing full on. And so good

25:28thing Bernanke brought interest rates down to zero, right? So what Bernanke has just outdone what Greenspan did, and I don't say this to be flippant or pessimistic, but I think people need to prepare themselves for the idea that in 2011 or 2012, we're going to look back at this and say, oh, wouldn't it have been great if we just had gone through the crunch in 2008 instead of Bernanke lowering interest rates to zero, the same way in 2008, people were saying, man, if Greenspan had just let us suffer the dot-com bust at the time, that would have been a piece of cake compared to One other general point is, there were real mistakes made during the housing bubble years. Real resources were misallocated, there was too much went into housing, Americans over-consumed.

26:20They spent too much money, they were borrowing, they weren't saving out of their paycheck because their stock portfolio was going up and the price of their home was going up, So they didn't save enough out of their current income thinking that they didn't need to because their overall wealth was going up. So you can't undo those mistakes just by having the Fed create a trillion dollars or create ever more trillions according to what the pundits want. So something has to give, and this notion is ridiculed in the blogosphere. People call this a puritanical thing that, oh, there needs to be suffering to atone for our sins. Well, you can call it that if you want, but it has to do with the fact that, no, there's more to an economy than just dollar bills floating around. There's actual real resources, and you can't undo those mistakes just by magically creating trillions of dollars in paper money.

27:05So it's shocking that we've come to that now. What I would think would be obviously recognized as monetary cranks are now the ones gaining currency, no pun intended, in the punditry class. Class, and what's funny is the way they know, this is what I'll leave you with, the reason they know that the Fed hasn't done enough yet, even though if you look at this chart, there are people saying the Fed obviously hasn't done enough because look, they should go up higher. And what's their proof that the Fed hasn't done enough is we're still in this thing. If the Fed had done enough, we would be out of this and we'd be in full recovery. So clearly the Fed has not printed up enough money. That is truly their argument. how they prove it that the FED has not been easy enough is that we're still stuck in this thing so you know you want to just say well okay but suppose for the sake of argument that printing

28:00up money is not the way to get a recovery then what you're saying would just be ten times worse wouldn't it and it was well sure but that's that's what they they suggest but they think no it's printing up money is the solution so it's I wish I could give you some you know diagnosis or explain and these real highfalutin theories but I mean it really just it's that naive and basic that they think printing up money is the way to prosperity and so what more can you do besides saying well it hasn't worked so far and it just doesn't make any sense even in theory so with that happy note thanks a lot