Why you don't need banks for the economy to recover

The Economy drives Banking, Banking does not drive the economy

It is an article of faith that you need healthy banks for the economy to recover. The logic goes that if banks aren't healthy, they won't make loans, and if they don't make loans, the economy cannot grow. A bank is "unhealthy" if it is undercapitalized -- that is to say that it does not have enough equity to meet capital requirements, and therefore cannot engage in additional lending. (Under law, this condition would also trigger FDIC receivership, but that law does not seem to apply today.) If a bank was to write down the value of its assets, then it would also need to write down the value of its equity, and thus put itself into FDIC receivership. Etc.

While the mechanics of the above are true, it is not true that restricted bank lending is causing this "crises". Although it is called a "credit" crises, it is in fact a fall in aggregate demand. Aggregate demand is consumer spending plus consumer investment plus government spending minus taxes.

When the private sector, as a whole, wants to spend less and save more, aggregate demand falls. This increase in savings shows up as an increase in inventory, which gets counted as investment but is nothing like what we would imagine true investment to be (factories, bridges, etc.) Moreover, you will also see credit fall, as instead of taking out money to buy things, people simply pay down existing debt or hoard cash in the bank. The causality is backwards: lower aggregate demand is reducing credit, lower credit is not reducing aggregate demand. Similarly, the cycle will turn the same way: higher aggregate demand will increase the demand for credit, more credit availability will have no impact on aggregate demand if the private sector is still in the midst of deleveraging.

Moreover, falling aggregate demand reduces the private sector's ability to service debt loads, which is what reduces the asset (receivable) quality of banks balance sheets. If you lose your job, you're more likely to default on your mortgage. Again, the received wisdom gets things backwards: bad balance sheets are not harming the economy, the bad economy is harming balance sheets. Once aggregate demand begins to grow, balance sheets will "magically" fix themselves.

Banks are not nearly as important to the economy as they claim they are.

Obama's Bank Bailout enriches Bankers, but does not help the real economy

Obama claims that the banking bailout is critical to get the economy back on track. He is wrong. The banking bailout is critical to lining bankers' pockets, but no more. A growing economy will fix banks, just as it will generate additional lending, which will create more deposits, and additional (real) investment, which will create more savings. Sound lending is important to an economy, but banks are procyclical, and a lagging indicator, not a leading one.

When Regulation cannot work, Fear must

This self-serving "logic" is clear in this resignation letter, which somehow found its way into the NYTimes: AIG: I quit. It will be interpreted as the reason why the US Govt should not claw back the absurd bonuses given to bankers by those who believe that banks are critical to getting the economy back on track. If a regulatory system is continually and systematically gamed, as the financial system clearly does, then the answer is never more regulation (which will simply be gamed around), but retroactive penalties on bad actors. If you cannot set up the right rules in advance, then you must move the goal posts after the fact.

People who claim that the AIG bonuses are small potatoes miss the point: they are very big potatoes to the actors who received them and incentives are a critical factor behind all of this.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money.

Because he got lucky. Or not. The point is that in every other business, firm profitability impacts individual and group level compensation. If your firm makes net minus infinity, you don't get anything.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

Also wrong. In a word where regulations exist only to be "innovated" around, fear must be the prime motivator, as rule of law cannot be. The CEO should be afraid that all of his money will be confiscated if he blows up the world financial system. He must create compensation structures that massively impoverish people if they blow up the world financial system. Employees must keep a close eye on each other, in case someone is doing something that will blow up the world financial system. This is called "risk management" and it is something that the financial industry should try.

Tax Payer "Profit" is an Oxymoron

Taxpayers, aka the Government, can print all of the money they need, anytime they want. The very concept of "profit" to a currency issuer is completely nonsensical. Their only goal should be maximizing the quantity of real goods and services in the economy, long term.

Some Government actions may cause a higher budget deficit, but put in place better incentive structures to prevent capital misallocation and financial blowups in the future. The true cost of this crises is not just the trillions going down the drain now, but also the trillions misspent on McMansions in the middle of nowhere, empty shopping malls, and office buildings that no one will ever fill. Those represent real opportunity cost. Moreover, the double digit unemployment rate, shuttering factories, and collapsing businesses are real capital destruction too. It is completely worthwhile to run a higher deficit, get capital reallocated correctly, and have a banking system in perennial morbid fear of blowing up.