Discover more from Economics Matters by Laurence Kotlikoff
Debt Default and a Banking Panic -- Take Cover!
Both are coming to a theater near you.
The House Republicans just passed a bill to raise the debt ceiling. The bill is not simply dead on arrival. It’s being repurposed by Democratic Senators as toilet paper. The bill would roll back almost all of President Biden’s legislative victories, including environmental initiatives, and require poor people too sick to work to work in order to afford to be sick. No worky, no healthcare, i.e., no Medicaid. Also, you tired, you poor, you huddled masses yearning to be fed. No worky, no eaty, i.e., no Food Stamps. So work, but not too much. Because if you do, those Medicaid and Food Stamp benefits, well, we’ll take them away. After all, you won’t need them.
Yes, this is mean and nasty. But most of us are angry people who haven’t cracked a smile in decades. These days we’re really angry. Most of us know the Democrats not only stole the Presidential election. They stole every election they “won,” including those for dog catcher. Who told us? Someone named Q. He/She/It also confirmed we won our own elections fair and square.
Q’s not woke enough for you? Too bad. Most of us will be re-elected in 2024 no matter what we say or do. So, we’re going to finish what we started on January 6th.
Segregation, opps, Insurrection now, insurrection tomorrow, insurrection forever! If this means forcing our government to default for the first time in its history, well, that sound just fine to us. Our patriotic goal is to destroy America as we’ve known it and rebuild it the way Q says.
What these folks don’t get is the canes and walkers and bed pans that will be hurled their way after the Treasury decides to stop sending out Social Security checks rather than reneging on interest and principle on federal debt. The later would destroy America’s reserve currency status. The former will help the Republican party achieve its clear mission — to destroy the Republican Party.
This isn’t my prognostication. It’s the market’s. The one month T-Bill yield has dropped dramatically. This means its price has risen. You don’t pay a higher price for a bond when the prospect of its default rises. Yes, the bookies put the chances of “default” at 35 percent. But this apparently references the odds of not raising the debt ceiling rather than failing to service the debt, roughly a quarter of which is owned by foreigners. (This share, by the way, is down from one third a decade ago — a troubling sign for sustaining U.S. financial hegemony.) As for five-year yields, they have hardly budged in the past month and are too low to read in any real prospect of debt default.
For their part, the Democrats have done nothing to help the Republicans turn from self destruction to reconstruction. President Biden has rightfully refused to negotiate with a fiscal gun pointed at his head. But he could be working with House Republicans who come from blue/blueish districts and would likely vote for a purple policy — one that advances both parties’ core interests. (Yes, the Republicans still have some core interests beyond destroying Disney, banning books, jailing those who cross state lines to have abortions, stealing elections, and genuflecting over their beloved MAWA — Make America Worse Again.)
Peeling off a handful of moderate Republics to vote purple is all that’s needed. The House Republican bill was passed by a majority of two! And not all of the bill’s supporters were mindless merchants of mendacity. Some get that the country is fiscally insolvent, that we are making money the old fashioned way — by printing it, and that every fiscal institution, from Social Security to our largely nationalized healthcare system to our byzantine tax system, is unfit for national economic survival. They also get that the Democrats have no plans whatsoever to fix anything in the manner needed — from the ground up. Instead, the Democrats are sure that every structural problem can be successfully papered over in green.
To be clear, whether the government defaults on its implicit debt to pay Social Security benefits, cancels federal contracts, closes the national parks, furloughs federal employees, or stops servicing official debt, the U.S. financial markets will take a massive hit. And Treasuries will be downgraded, making our nation’s borrowing costs higher — for years.
Train up the 300 miles of decayed tracks from K Street to Wall Street and you’ll find a no less lethal financial crisis brewing. I’m taking about our not-so-slow-mo banking panic. Over the top? Well, return to January 2007, when financial giants from Bear Stearns to Merrill Lynch, to AIG, to IndyMac, to Washington Mutual, to Fanny Mae and Freddie Mac, to Lehman Brothers, stood tall and proud, little knowing their chances of imploding within 24 months were a million to one.
SVB, Signature Bank, and Credit Suisse were sitting high in the saddle just two months back. Today they are financial ghosts, vying for a place in our long-term memory of major bank runs. And this morning, they were joined by First Republic, which was impounded by the FDIC and instantly “sold” to JPMorgan in a shotgun wedding.
To seal the “sale,” the FDIC took a $13 billion dollar hit (Question. Does the FDIC have any money left?) and made what is surely a sweetheart $50 billion loan to JPM. Paying JPM under the table in broad daylight is now de rigueur. Recall the Fed’s purchase of Bear Stearns’ sub subprimes, via a fund called Maiden Lane, at what was surely a highly overinflated price. It was the bribe needed to get JPM to buy Bear at less than the cost of its Manhattan headquarters. (Maiden Lane, btw, is the street running at the rear end of the NY Fed. Get the inside joke?)
First Republic replaces SVB as our nation’s second largest bank failure. SVB moves to third place and Signature to fourth. This is pretty impressive set of bank runs, occurring, as they have, over a scant seven weeks. As the Great Recession shifted into gear, there was a sixteen week pause between the collapse of Bear Stearns and IndyMac.
The Wall Street Journal says, “the chaos has since quieted.” Its proof? It found one out of our country’s millions of MBAs, in this case a Yale researcher named Steven Kelly, to opine, “This is the last stages of (the) initial panic. … This isn’t the story of 2008, where one bank went down and investors focused on the next biggest bank, which would wobble.”
I’m wondering what the Journal’s reporters and Steven are smoking. There’s nothing “quiet” about the second largest bank failure in U.S. history and there’s nothing in that failure that suggests this crisis will end. On the contrary, First Republic lost $100 billion in uninsured deposits in just the last few weeks. This is part of the $1 trillion plus uninsured deposit run we’ve seen since SVB failed on March 10th. There are still some $7 trillion uninsured deposits in the banking system available to run. First Republic’s demise could accelerate their departure to the safety of mutual funds where one’s money is parked in assets that one effectively directly owns — not in some 90 percent leveraged bank that may not be long for this world. Uninsured depositors might be more inclined to hold tight were the extant banks in good shape. But over half of these financial dinosaurs are currently bankrupt when their assets are marked to market.
Then again, Michael Barr, the Fed’s Vice Chair for Supervision told us last week, not to worry. Yes, there was a breakdown in supervision, but, and here I’m paraphrasing, the problems will be fixed. They’ll never happen again. Rest assured, the financial system is solid.
Gee, those words sound strangely familiar.
Charlie Munger, Warren Buffett’s long-time partner at Bershire Hathaway, has a different take on the banks, particularly their commercial real estate holdings. “A lot of real estate isn’t so good any more,” Munger said. “We have a lot of troubled office buildings, a lot of troubled shopping centres, a lot of troubled other properties. There’s a lot of agony out there.” Banks, he says, are “full” of these “bad loans.” In short, far more than half the banks may be bankrupt were one to mark to market not just their “safe” Treasury and similar long-term bonds, but also their real estate loans.
How can our nation escape debt default and a full fledged bank run? The only way the Reds and Blues can avert catastrophe is to change the subject and discuss an entirely new fiscal system over which neither party has a dug-in position. This column suggests how we can redesign our entire fiscal enterprise in a way that is fiscally sustainable, progressive, equalizes work incentives, and ends the poverty trap. Surely, an agreement to negotiate a new fiscal compact along these lines would end the debt-ceiling crisis.
As for our banking system, the Three Musketeers — the Treasury, the FDIC, and the Fed — should do three things. 1) Announce FDIC insurance of all deposits. This will, hopefully, end the run by uninsured depositors. 2) Strongly incentivize all banks to stop taking deposits and start issuing equity-financed mutual funds, particularly closed-end funds that purchase mortgages and small and large commercial loans. 3) The Three Musketeers would establish an online system of real time valuation and disclosure of closed-end fund assets. This would ensure a highly liquid secondary market in the shares of these funds.
Existing mutual fund holding companies can help the transition to Limited Purpose Banking (LPB) by issuing cash mutual funds that hold one thing and one thing only — cash. The funds would charge a fee to facilitate the use of these accounts for transactions, via ATM withdrawals, check writing, and use of debit cards. Together with the existing 7000 equity financed U.S. mutual funds (primarily open-end), the closed-end and cash mutual funds would largely implement LPB. Banking crises, like the use of doubloons, would become a thing of the past.
Rational solutions like those I’ve just proposed are unlikely. How then should you find shelter from the storm? You could exit the market, short the market (quite expensive and risky), buy gold, silver, platinum, etc., short bank stocks (quite expensive and risky), invest in real estate (yes, nominal mortgage rates, but not real rates are very high), add an addition to your house, buy foreign currencies, pay off your mortgage, invest in the stocks of mutual fund companies, pay off your kids’ student loans, buy art, or …. I don’t have foolproof advice. Nor does anyone else. But it’s time we all raise our antennae. In the end, it’s doom alone that counts.