Apr 3, 2009

What Does "Too Big To Fail" Mean?

Have you heard of the boom bust towns of the olden days? Lets start there. If a town pops up around one industry, say mining, and the mine goes dry. Then all the workers will be out of work. No one will have any money for groceries or any other commodities available in the small shops and the town will become a ghost town. The mine was the main industry and it's failure led to the towns extinction. From the point of view of the towns economy the mine is 'too big to fail'.

Lets say there is a two industry town. A fishing industry with a built up port and a mine in the nearby mountains. If the mine goes dry the fishing industry will still be around. If the mine employed 50 - 70 percent of the towns labor then the town will go bankrupt, many workers will leave, many shops will close. The town will not cease to exist as there is still the fishing industry. However, economic growth for that town will be the equivalent of a depression. So from the point of view of the town's economic growth the mine was 'too big to fail'. [The financial sector is like a hug mine that has come to dominate the economic landscape - for a visual image see the pie chart below - this trend has spread to all countries as they participate in global trade for their own economic growth]

We can go on multiplying the number of industries (which is what economists do - start with a model of one industry and build it until it takes many variables of an economy into account). I'm guessing you get the idea and so I want to move to our current financial structure.

The following is a graph from Wikipedia on "Financialization" (the only place I could find the info I was looking for). The stated source is "Annual Reports of the U.S. Commodity Futures Trading Commission". I can't confirm the primary sources but the graph looks almost the same as the ones I studied in basic macroeconomics in college. When I have more time I will double check and change it if it's not accurate.

Note: What I am looking to show you in the graph is the distribution of the financial sector over time. In the olden days agriculture took up most of an average countries economy. Nowadays it's a small percent of the economy. In other words, it's like having a huge mine in our fishing town which has made as rich. But we are rich because of the mine. If it falls we will have to go to a huge adjustment period till the economy stabilizes at current output levels (i.e. the economy with a very small financial sector - like the mine going down to a trickle). This adjustment period is called a depression.

Short extract: For a century after organized futures exchanges were founded in the mid-1800s, all futures trading was solely based on agricultural commodities. But after the end of dollar gold-backed fixed-exchange rate system in 1971, contracts based on foreign currencies began to be traded. After the deregulation of interest rates by the Bank of England, then the U.S. Federal Reserve, in the late 1970s, futures contracts based on various bonds / interest rates began to be traded. The result was that financial futures contracts - based on such things as interest rates, currencies, or equity indices - came to dominate the futures markets.

As the graph shows the share of our local and global economy connected to our financial markets is huge. The banks and other financial institutions have been selling financial derivatives based on other financial derivatives and their sales of these financial instruments is what has boosted the reported GDP. If we were to ignore the economic boost we are supposed to have had from our financial institutions for the last several years, we have actually been in a recession for quite a while. This financial crises has been a long time coming. What we basically did was sell financial instruments for 30 dollars with the backing of only 1 dollar (to take an example from the President from his interview with Jay Leno). To look at it another way, we were selling trucks set up on wooden stools.

Now, go back and look at the graph. It doesn't represent all of the financial derivatives our 'talent' came up with. Alot of the financial instruments have actual assets backing them up but because the derivatives are connected to real assets - over inflating them and creating a 'bubble' - all the companies who deal in these instruments are in serious financial trouble. Notice how large of an economic share they have in America's local economy. The major financial companies have grown large enough to own a large share of the financial instrument market - across many countries (A company has global reach and influence). So the problems here are reflected all over the world.

From the point of view of America's economy the financial sector is like a huge mine that has slowed to a trickle. There are still other industries but they can't make up the difference. In other words, from the point of view of the economy and it's economic growth, 'it's too big to fail'.

That's not all. These instruments have been sold to many other countries so their assets have become toxic as well. The US has a 14 trillion dollar economy and so does the European union. The world economy is estimated at 70 trillion (source CIA factbook). If the US financial companies are allowed to collapse it will effect the European union and other big first world countries and with it the rest of the world. The banks are literally 'too big to fail' for the entire planet.

His is a good article:

How can we prevent a financial crisis becoming a crisis for the wider economy?

There is no doubt that the crisis in the banks reflects an underlying misallocation of resources in the real economy. Too much money was being spent on some things, and not enough on others. In particular too much was being spent on things that do not generate future income – like bigger (and more expensive to heat or cool) houses and consumer goods – and not enough was being saved to meet the retirement and medical costs of retiring baby boomers.

But could we have corrected the misallocation of resources more slowly, and without sudden falls in stock markets and without a gridlock in the provision of bank credit? In other words, how might we have avoided turning a problem into a crisis?

This is the question tackled by a board member of the European Central Bank, Lorenzo Bini Smaghi, in a speech he made in Milan last week.

Lorenzo Bini SmaghiHis thesis was that what turned a problem into a crisis was the decision to allow Lehman Brothers to fail.

He said that in previous months authorities had intervened to save other institutions – Northern Rock, IKB, Bear Stearns and Roskilde – but the decision not to do so in the Lehman Brothers case changed the psychology of investors dramatically.

As he put it:

“Following the failure of Lehman Brothers, panic set in that any bank, irrespective of its size, could go bankrupt. Market participants revised their investment decisions. The banks themselves started to fear that any of their counterparts could fail and stopped lending money to one another.”

In the four weeks after that, European stock markets fell by 30%, which was more than the total fall in the previous year. An orderly retreat became a precipitate flight - and everyone has suffered more than they needed to.

Lorenzo Bini Smaghi believes that this happened because there was what he called a “political veto” on a rescue of Lehman Brothers in both the Administration and Congress, a veto which reflected public opinion. He believes,

“it was US citizens who did not want to rescue Lehman Brothers.”

Bini Smaghi believes that, while objectively it may have turned out that it would have been in citizens’ best interest to rescue Lehman Brothers, the citizens themselves did not see it that way at the time.

He attributes this reluctance to support a Lehman rescue to an accumulating feeling that the rewards in society had not been distributed fairly over many years. In his view, Lehman Brothers was seen as just one step too far to go to helping people who had done far better than the ordinary American had done during the boom times.

He says that income inequalities have risen in both the US and Europe since the 1980s and that these Banking widening differences in incomes had “disproportionately favored the financial sector.” Profits in the financial sector in the last few years amounted to 40% of all corporate profits, which was double their share in the 1960-2000 period. [US Federal Reserve Board] Chairman Bernanke has also drawn attention to widening income gaps and the reasons for them in speeches. Bin Smaghi argues that the public’s sense that this was not fair worked against a rescue of Lehman Brothers.

His conclusion is that inequalities in income have implications for future policy-making. He says:

"the emergence of stark inequalities entails the risk that decision-making mechanisms will be blocked, in particular in crisis situations, with negative repercussions for the collective good and social cohesion."

This is an especially important conclusion for the financial sector because, as the dramatic events that followed the bankruptcy of Lehman Brothers have shown, the financial sector is vital to the whole business system in a way that no other business sector is.

On the other hand, one should recognize what Chairman Bernanke has said in recent speeches regarding the failure of Lehman.

He has pointed out that the Fed had wanted to save Lehman but was unable to do so as it could not find a private institution willing to post adequate collateral against which the Fed could lend. In the Bear Stearns case, this rĂ´le had been played by JP Morgan Chase. In the case of Lehman, despite working very hard with CEOs of leading banks, the Fed simply could not find a willing financier. In this particular case, Lehman may have been both too big to fail and too big to save.

WorkersThe plan of action announced last month by G7 Finance Ministers gives a clear commitment “to use all available tools to support systemically important financial institutions and prevent their failure.” I believe that this commitment, together with the comprehensive measures announced by Euro Area Heads of State at their Summit on October 12, have helped to reassure markets and significantly reduced the chances of another event like the failure of Lehman Brothers occurring.

Another article: Barely a week after Europeans rebuffed American pleas to join in their bailout of the banking system, Europe now faces a financial crisis almost as grave as that in the United States — demonstrating how swiftly this contagion is spreading around the world.

In the last two days, governments from Dublin to Berlin have seized or bailed out five faltering banks. In Ireland, where rumors of panicked withdrawals from banks spooked the stock market, the government has offered a two-year blanket guarantee on all deposits and bank debt.

Asia has been less buffeted by the turmoil, though a brief run on a bank in Hong Kong last week brought back dark memories of June 1997, when speculation against the Thai currency sparked a financial crisis that fanned rapidly across Asia, and later to Brazil and Russia.

Economists see a parallel between these two crises a decade apart: once creditors panic and begin to pull out their holdings, the underlying health of banks — or entire countries — no longer matters a great deal. In a global financial system, national borders are porous.

"In this day and age, a bank run spreads around the world, not around the block," said Thomas Mayer, the chief European economist at Deutsche Bank. "Once a bank run is under way, it doesn't matter anymore if you have good loans or bad loans. People lose confidence in you."

If you look at the post on the multiplier effect you will notice that spending money in an economy leads to more spending by the people who get the money and this continues which increases money circulation in the economy. If the entire economy runs on domestic goods then all the money stays in the particular countries economy. In today's global economy the money goes all over the place, all the money spent by the government, although it will help shore up essential services and boost jobs, it will not all stay in the economy. That is how it is with all the countries on this planet and it's why we had this huge global economic boost (before the weird financial derivatives).

Our American economy is about 14 trillion in size. So far the spending bill is less than a trillion. If you look at the graph above you will immediately realize that that is not enough to prop up the huge impact - in trillions of dollars - that the financial industry collapse will have.

Large infusions of real capital is still necessary to boost our national economy and if possible we need to get the Europeans involved in boosting their economies as well. Poor people spending more is not the way we are going to save our economy. That will happen anyways after the trust in out economic markets returns.

Note on bonuses: We can get 'talent' for financial companies all over the place. The hire the people who got the best grades and have the best connections. If they overlook the connections they can still get 4.0 gpa people in their companies. Coming up with weird financial derivatives in an unregulated financial system is not talent. And what percent their bonuses are in relation to GDP in irrelevant. The issue is company management and this has nothing to do with the GDP.

Once again look at the graphs above and think....what if we let our financial sector collapse? I think the answer is obvious. This is just 'too big to fail'.

For more perspective:

The Colbert ReportMon - Thurs 11:30pm / 10:30c
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1 comment:

  1. EDIT: :Our American economy is about 14 trillion in size. So far the spending bill is less than a trillion. If you look at the graph above you will immediately realize that that is not enough to prop up the huge impact - in trillions of dollars - that the financial industry collapse will have."

    Note: The graph was from wikipedia which is now gone. Simply look for a non-US source (just to be sure of accuracy, try the UK) for economics graphs of the sectors of the economy for the USA to confirm my accuracy, i.e. "Sectors of the Economy and The Chain of Production" http://economics-proofs.blogspot.com/2011/09/sectors-of-economy-and-chain-of.html