If you have time, there are two long articles that are worth a read.  The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.  It was written in three parts — one, two, and three, corresponding to three phases:

  • Growth of a clever enterprise, AIGFP.
  • Expansion into default swaps.
  • Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.

What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”  There is no free money, but the lure of “free money” brings out the worst in mankind.  This is not just true of businessmen, but of politicians, as I will point out later.

My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.  Boy, were they arrogant!  It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.

As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.  The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.  Again, the AIGFP people were arrogant — but what was I to say?  They were more successful, seemingly.

The last era, as AIG got downgraded, was while I wrote for RealMoney.  After AIG was added to the Dow, I was consistently negative on the stock.  I had several worries:

  • Was AIGFP properly hedged?
  • Were reserves for the long-tail commercial lines conservative?
  • Why had leverage quadrupled over the last 15 years?  ROA had fallen as ROE stayed the same.  The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
  • Was AIG such a bespoke behemoth that even Greenberg could not manage it?
  • My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.  (I was privy to a number of significant reserving errors 1989-1992).

In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.  AIG fit that mold well.

Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.  This is only an opinion, but I think AIG stock is an eventual zero.  Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.  Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.

The second article is from Bethany McLean of Vanity Fair.  I remember reading her writings during the accounting scandals at Fannie Mae.  She was sharp then, and sharp now.  There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:  I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.

Again, there is a growing bubble, as with AIG.  The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.  It also leads them to buy the loans made by their competitors.  It leads them to lever up even more.  It leads them to dilute underwriting standards.  Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.

One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.  On a cash flow basis, that might not happen for a long time, but it would happen.  Defaults would be well above what was their worst case scenario, and too much for their thin capital base.

The last article is another three part series from the Washington Post that is about the failure of our financial markets.  (Here are the parts — one, two, three.)  What are the main points of the article?

  • Bailing out LTCM gave regulators a false sense of confidence.  They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
  • Because of turf and philosophy conflicts, derivatives were left unregulated.  (My view is that anything the goverment guarantees must be regulated.  Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
  • The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.  The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
  • Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
  • The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.  Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.  Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
  • Standards fell everywhere as the party went on, and the bad debts built up.  It was a “Devil take the hindmost” situation.  But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.  Cash, cash, who’s got cash?!
  • In the aftermath, regulation will rise.  Some will be smart, some will be irrelevant, some will be dumb.  But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.

A few final notes:

  • Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
  • This could never happened as badly without the misapplication of monetary policy.  Greenspan enver let the recessions do their work and clear away bad debts.
  • Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
  • The investment banks relied too heavily on risk models that assumed continuous markets.  Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
  • The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
  • The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.  But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.  We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
  • With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.  Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
  • As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”  And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.  I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.  For that, I apologize.  It is what I hate most about investment writing — people losing because they listened to me.

Should the Fed have intervened on LTCM?  My answer is no.  It set up the seeds of the present crisis, and encouraged the Fed to meddle in places where there is no significant legal basis to do so.  If they had let LTCM fail, the debts of the system would have shrunk more, and the system would not have failed, as it seems to be doing today.  It would have been a salutary check that would have brought us back to reality.  (Now, would that they had not loosened so much in 2002, 1995, and 1991, but that is another story….)

The failure of LTCM did have some positive effects on me.  It made me more skeptical about arbitrage, leverage, and illiquidity, at least to the degree that one has to be paid to take on these risks.  Also, that hedge funds as a group posed some systemic risk, even if none were as big as LTCM.

But now consider a problem in our future.  Is Social Security a Ponzi Scheme?  (I like Eddy and Jim, so this is not about either of them… I have been writing about this for 15 years.)  I don’t typically call it that, not because there aren’t some elements that resemble a Ponzi Scheme, but because it loses the writer credibility on the broader issues involved.  Rhetoric matters, and even tone of voice matters.

In analyzing Social Security and Medicare, the first thing one must do is unify them with the US Government, and consider them as a whole.  The US Government has moved two two plans off-budget and on-budget at their convenience in order to make the deficits look smaller.

When one looks at the system as a whole with current US Government borrowing, one sees the imbalance.  Many say, “The trust fund won’t run out of money until 2042,” or “Inflows will exceed outflows until 2022.”  The trouble is, we are at the peak now of inflows over outflows.  Starting four years from now, when Obama is a lame duck, that overage will shrink.  As the overage shrinks, taxes will have to be raised, or borrowing will have to rise.  And all of this is on top of what we have done in 2008, and will do in 2009, where the deficits are as aggressive as in wartime.  From an old CC post:

David Merkel
Every Little Help Creates a Great Big Hurt
8/23/2007 5:09 PM EDT

So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.

But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

Position: long tax payments

I have focused on the latter half of the 2010s as my period for when the US will face a crisis, because then it will become obvious that the US can’t make good on all of its promises.  Well, the government is testing the boundaries of crisis now.

What everyone who relies on Social Security and Medicare should know is that those programs are subject to the will of Congress.  They could eliminate them tomorrow and no one could sue for damages.  “Wait, I paid into that for 40 years!”  Sorry, you paid extra taxes for 40 years, the law had no provision guaranteeing results for any individual.

All of that said, I am reminded about what former Senator William Proxmire said about Social Security.  (I met him at my High School when I was 16 — when I shook hands with him, there was no one else there, just me and him; I felt honored, particularly as he was a rare politician at that time who would not spend aggressively to win elections.)  He said that all Social Security benefits would be paid, but the purchasing power of those benefits would be limited.  That is a common sense warning from a man who knew that you can’t get something from nothing.

That brings us back to the present.  You can’t get something from nothing.  Why should you expect the government to rescue us from this crisis?  Who will lend us the the money/resources?  What return are they expecting?  What happens if we default?

I’m not specifically worried about Social Security anymore, because we are presently testing the boundaries of what the US Government can borrow at present.  I don’t precisely know where that limit is.  In implicit terms, we are past the debt limit if one includes that Social Security deficit.  But foreign powers, OPEC and China, can fund the US for their own reasons, even when US creditworthiness is scant.

If I were advising the governments of Saudi Arabia or China, I would tell them: sunk costs are sunk.  Do what maximizes value for your people from here.  That might break the current cycle where they support the US.

What I have written here outlines what we might expect over the next decade.  I hope and pray that matters prove better than what I expect.

I have argued before that the flawed accounting standards of the FASB are superior to those of the IASB.  I will argue that again, as IASB has compromised its integrity by giving in to the EC.  It is easy to give into pressure as firms with bad balance sheets scream for relief, presuming that markets don’t ignore the accounting, and assume that asset cash flows are inadequate to pay for liabilities.

EITF 99-20

Following Jack Ciesielski, I have written the FASB on EITF 99-20.  Here is what I wrote:

Accounting is properly done using discounted cash flows, rather than management judgment.  The value of an asset is the cash flows that it will likely generate, discounted at a rate appropriate for the risks thereof.  I am a life actuary, and I believe that where cash flows can be reasonably projected, that forms an adequate basis for calculating the value of assets.
So, don’t change EITF 99-20.  It provides better guidance than a management’s judgment would.
David J. Merkel, CFA, FSA
There are no perfect accounting rules, and cheaters will always find a way to abuse the rules.  Management judgment can be a good thing where cash flows can’t be reasonably estimated, but where cash flows are clear, managements should discount them at rates appropriate to their risk.

I’ve written on mark-to-market accounting before.  Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism.  It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make  reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved.  The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment.  But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power.   Many assets have not been marked down to their fair value.

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid.  When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model.  It is the best that can be done.  But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm.  Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting?  Of course, in the short run.  In the intermediate-term, the errors catch up, and destroy the cheater.  In the long run, cash flows determine the value of a business.

So, be wary in the present environment.  Just because a financial institution trades below book value does not mean that it is cheap.  Much of the cheapness stems from the opaqueness in pricing of unique risks.

The challenge is analyzing what an asset is truly worth, and when that value can be realized.  That is the challenge with financials today.

I am not a gambler, and I never will be.  I take the risks of a businessman as I invest, and not those of a speculator.  I found it interesting to to read this Wall Street Journal article where public defined benefit pension plans are not fleeing hedge funds.  This is an area where I half agree.  Because the yields of high yield bonds are so high, this is not a time to abandon aggressive strategies.  Rather, it is a time to embrace them, slowly and carefully.

I looked through the database of my writings in the CC at RealMoney, and I found these two comments that fit the moment well.

David Merkel
Avoid Esoteric Diversification
4/13/2006 4:00 PM EDT

This isn’t a burning hot issue at present, but I have been impressed with the increasing amount of money getting thrown at esoteric asset classes by pension plans and endowments, in an attempt to diversify and gain higher total returns. In the intermediate term, it is not sustainable. For now, party on, we are in overshoot mode.

By esoteric asset classes, I mean: commodities, timber, credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of asset- and mortgage-backed securities, hedge funds and private equity.

Many novel asset classes provide both higher returns and diversification when they are first used. As more and more players get comfortable with it, they buy in, lowering the required total return needed to attract investors, but pushing up returns to pre-existing holders as the price rises.

This can be self-reinforcing for quite a while, with a lot of money blindly flowing in, until some player games the system, selling securities that fail miserably. A panic ensues, and the asset class goes through a maturation process that learns to distinguish quality within the asset class.

With the rise in yields, high quality bonds have been giving holders a hard time in total return terms. But you don’t buy bonds for total returns; you buy them for income, and diversification; they tend to do well when risky assets break down.

I guess my short summary is this: with risky asset classes so highly correlated at present, if you want to diversify, go to high quality bonds, or cash. The theoretical diversification of risky assets based on correlation measures calculated over long time periods is no longer valid.

Position: none

and —

David Merkel
Alternatives to the Terror of Actuarial Funding Targets
9/27/2007 2:57 PM EDT

Jordan, my deep suspicion with respect to the pension plan sponsors is that they are looking at the gap between the yield they can get from investment grade bonds and the yield they need to fund the pension promises, and they realize that they are going to have to make a larger allocation to risky assets. After that, they look at the past track record on public equities, and conclude that they have been hurt by the lack of returns over the past seven years. Then they look at the returns in alternative investments, and say, “What great returns! Why have I been ignoring these? If David Swensen can do it, so can I!”

Well, David Swensen is a bright guy who went to the party early. Alternative investments were truly alternative when he arrived. Today they are mainstream, and some of them have gotten overfished. The plan sponsors can allocate all they like to alternatives, but they aren’t magic… they can do just as bad as public equity, and with far less liquidity.

If I were a plan sponsor today, I would begin trimming alternative areas that look crowded, like private equity, commercial real estate, and certain types of hedge funds while the door is still open. For some areas, like CDOs [Collateralized Debt Obligations] the door is already closed.

I would also lower my return expectations, and plan on contributing more. Heresy, I know. But alternatives are over-used, and no longer alternative. They won’t deliver the same high returns in the future that they did in the past.

Position: none

I am not unsympathetic here as public pension plans essentially say, “Well we have to earn enough to meet our actuarial funding targets, and at this point, bonds of the highest quality don’t help us.  Hedge funds promise high returns regardless of market movements, so we need to allocate money there.”

At this point in the cycle, I might have some sympathy, because enough arbitrage relationships are broken, offereing some opportunity.  At the same time, and ordinary investment in a basket of lower investment grade and high yield bonds offers a nice return for those willing to live with some default risk, which is over-discounted here, even with things as bad as they are.

In a bear market, once you have taken a severe amount of damage, the question is “what offers the best return from here?”  The answer might be unpopular, but it should be pursued.  Even as defined benefit managers pursued seeming diversification with bad payoffs as noted above, and should have sought long term guarantees, at a time like now, where guarantees are tremendously expensive, and yields are high  because of possible default, it is a time to take risk, and fund the best entities that may not make it.

These are ugly times, but we have to think like Ben Graham during the Great Depression.  What will survive?  Where can a little bit of additional capital spell the difference between death and survival?

This is a time to take risk.  Things could get worse from here, so don’t overcommit, but don’t fail to commit either.  Make some reasoned judgements about what is likely to do well ten years out, and invest for it.

This is a rough time.  I offer solace to those that are battling the markets; you are having a rough time of it.  The challenge here is whether the risk premium in fixed income assets offers enough compensation versus Treasury quality assets.  My answer is yes, realizing that this is a bumpy trade, and will require patience to receive the returns promised.

Bloomberg wrote a piece over the puzzlement that many in the Chicago School of Economics feel at the present time with all of the distress in the markets.  After all, don’t markets self-correct?  Sadly, no, not all the time, or, at least not with high speed during credit crunches.  (All of the econometric studies I have done note a weak tendency to mean reversion in financial markets, even excluding periods where there are credit difficulties.)

For markets to self-correct, it requires that economic agents have enough access to capital in order to make the investments necessary to arbitrage the differences between the markets that are in disarray.  It should be no surprise that during a time where credit is hard to come by, that there are potentially profitable arbitrages that are going begging.

Barry did a post today off of the Bloomberg piece, suggesting the death of the Chicago School.  I think that prediction is too early.

I am not a Chicago School economist.  I don’t like the neoclassical synthesis.  It posits human rationality in ways that make us robots, both individually and collectively.  I have been a critic of their methods through both behavioral economics and nonlinear dynamics, a la the Santa Fe Institute.  We need a new paradigm to replace the neoclassical synthesis.  It does not adequately describe how mankind behaves (and we have known that for 25 years — the models don’t predict well, either in micro or macro).

But the answer is not Keynesian policy, in my opinion.  Just because markets are unstable, that doesn’t mean that government action can stabilize them over the long run.  In the short-run, while credit is still easily available, yes, government action can work, whether through the Fed, subsidies, or tax incentives.  But Keynesian remedies don’t work when the government can’t easily tax or borrow in order to provide the stimulus.  We will face borrowing problems soon enough.

The answers are not to be found by asking the Chicago School or the Keynesians.  We need an economic theory that accepts the necessity of moderate booms and busts, where the government does little to try to correct the imbalances.  Moderate imbalances are normal, and if we try to eliminate the moderate busts, we get a series of small busts, followed by one humongous one.  We experienced easy money in the 20s, and in the 1990-2000s.  Easy money cured the moderate busts, but at a price.

A quick excursus: I agree that tight regulation of financial institutions is necessary if there is fiat money.  Controlling the money supply means controlling credit.  I don’t like fiat money, and would rather have a gold standard, but if we must have fiat money, then make life tough for the banks.  Restrict what they can invest in.  Regulate lending practices.

The present distress stems from both a lack of regulation and too much regulation.

Lack of regulation:

  • Lack of enforcement on bad lending
  • Leverage limits on commercial and investment banks were too loose.
  • Modest limits on the banks dealings with the non-regulated financials.
  • Regulatory arbitrage allowed depositary financial to choose weak regulators.
  • Failure to disallow investment in areas the regulators did not fully understand.

Too much regulation:

  • Lack of limits on Fed stimulus action (our “independent” central bank was/is compromised)
  • Tax deductions for residential real estate, including the home sale capital gains exclusion.
  • Limiting the number of rating agencies.

My view is that we eventually have to give our currency some backing and get the government out of the money business.  Until we get there the ride will be bumpy.  We need to transist back to an economy where credit is not easy, but not non-existent, and where total leverage declines.  Saving has to become a virtue again, which our present monetary policies will not encourage.

It is too early to declare the demise of the Chicago School, much as it should disappear.  But now we will get the test of the Keynesian School and I predict failure there; they will not solve our crisis.  The crisis will end when enough bad debts have been liquidated, and the financial system can begin lending normally again.  Call it unrealistic; call it the Austrian School if you like (I have not read and von Mises or Hayek), but it is what restores the financial sector, which cannot live with too much leverage once assets are deflating.

PS — The Bible says that the borrower is servant to the lender.  True enough, but if the lender is himself a borrower, like most of our banks, the proverb does not hold.  The only lenders that are truly soverign are those that control their own destinies, because they have no debt.

One of my readers asked to see my asset allocation questionnaire. Well, here it is:

Risk Questionnaire

How old are you?

When will you need the money at earliest?

When will you need the money at latest?

Most likely, when will you need the money?

Over the most likely horizon, what rate of return do you want to earn on your money, relative to money market rates and yields on high quality long bonds?

As a percentage of your assets, what is the most you could afford to lose over one year?

As a percentage of your assets, what is the most you could afford to lose over five years?

How closely do you want to watch your investments?  (Daily, Monthly, Quarterly, Annually, Never)


When I was the investment actuary in the pension division of Provident Mutual, I would run into investment risk analyses that would make my head spin. My main gripes would revolve around the squishy questions that they would ask, many of which had nothing to do with long term investing.

Thus, my questionnaire. Feel free to use/modify it as you like. I have found that it is very good at sniffing out an investor’s real preferences. The last question also helps me understand the nature of the investor, and how much input/output he wants to have.

Risk tolerance is more a question of time horizon and loss averseness than anything else. Bravery and cowardice play a lesser role, if they even have a role.

(graphic obtained here, by enrevanche)

I’ve subscribed to The Economist for 22 years.  IN my opinion, it is the best English language newsweekly in the world.  Every now and then they toss a game into the magazine.  This time, the Internet aids the game, in that you can download cards, money, pieces, and rules.

This evening, three of my eight children said they wanted to play the game with me.  How it happened: I had printed out the money, cards, pieces and rules, and I had The Economist open to its centerfold, and the one who recently scored well on the National FInancial Literacy challenge saw it and asked what it was.  I told him it was a game from The Economist, and that if he made the effort to cut the pieces of paper and get the pieces together, we would play the game.  Two other children joined in, and we started the game.

Now, ay my house, you learn about the markets atmospherically.  As one of my kids said, who is not markets-oriented, “Yeah, in school neither the teacher nor the students understood what was going on in the economy, but I was able to explain it.”  (That floored me.)  As for the children that played with me this evening, it was filled with “Dad, what does it mean by…?” and laughter over the concept of naked short selling, especially given the graphic on the board.  There were a lot of “teachable moments” from a home schooler’s point of view.

The board and cards are filled with the clever humor of KAL, The Economist’s main cartoonist.  The kids picked up the copious easy humor, while I smiled at the nuances that they missed.  We have not finished the game yet, and two of my other children have said they want to play the next game.  One more aspect of the game: it starts in an intensifying boom cycle, and moves to an intensifying bust cycle.  The business cycle concept is definitely taught.

The length of the game seems to be an hour at minimum, and I’m not sure what the maximum could be.  Already the children are learning aspects of negotiation.  After one child went bankrupt for the second time, she received a buyout offer, a contingent debt offer in exchange for a “Get out of Chapter 11 free” card, and a free offer of money with the condition that if she went bankrupt again, she would sell out for a price fixed now.  She chose the contingent debt offer, and we all said she made the right move.

It may not be Monopoly, but it’s a fun game, and it is free.  Give The Economist and KAL credit for a clever game that sheds some light on the current crisis in a fun way.

This is a wonky book, and not for everyone.  It details the actions of monetary policy in the United Kingdom for much of the 19th Century.  In Great Britain, that was a century of incredible growth, and yet stability of the overall price level.  The Gold Standard worked, and the UK Government di not try to cheat on it, as it did in the early 20th century before the Great Depression.

One of Bagehot’s main ideas was that during a crisis, central banks should lend at a penalty rate without limit, and that would re-liquefy the marginal banks in the system that just needed a little to get by.  Bad banks would fail; good banks would not need to borrow.  We can contrast that with present policy of the Fed to lend against marginal collateral at favorable rates.  Ain’t no chance of us getting out of the problem that way.  All we do is create a new class of arbitageurs to extract money from the taxpayers, or Treasury note buyers.

The mangement of a good central bank is very conservative, and keeps a reserve large enough to avoid all disasters.  This again is the diametric opposite of the Federal Reserve, which was not in a conservative posture, and believes it can solve all of the credit problems through the wanton expansion of its balance sheet.

For a classic understanding of central banking, do not read Ben Bernanke.  Instead, read Walter Bagehot.  If you want to buy it, you can find it here: Lombard Street: a description of the money market.  Or, you can get it for free here.

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  I’m not out to sell things to you, so much as provide a service.  Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.  I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.

At his excellent blog, Paul Kedrosky posted a piece on bank deposit guarantees across nations.  It included this graph:

Now I will give you an unusual analogy that reflects the story that this graph is telling us.  This is somewhat like what the Defined Contribution [DC] plan industry went through when it moved from annual valuation, annual redirection of monies, to quarterly, to monthly, to the eventual change your asset allocation once a day if you like.

With annually, a huge number of people would make moves. Quarterly, not so much, but it still increased the over all number of transactions. Monthly brought a decline in the total number of transactions. Daily? Few people transact because they can always do it.

So, when the guarantee is unlimited, few take advantage of it. When it is limited, people get far closer to the limit on average.

This is just another application of behavioral economics.  When something is free, people don’t value it as much, so they don’t use it.  When something is hard to do and valuable, they take every opportunity.  In between they act to some degree to preserve value at the appropriate dates or amounts.  After all they will have another chance soon.