Monday, September 22, 2008

Pre-history of the Paulson scheme

Folks have forgotten, but it was September 18 2002 when the Bank of Japan announced its surprise plan to buy stock from the big Japanese commercial banks, the historical ancestor of what Paulson et al are now trying to market to the Congress. The BOJ said it would buy up to 8.3 trillion yen-worth of stocks, which was the amount by which the banks' holdings of listed stocks exceeded their capital. BOJ said the price-risk pressure on banks from all that stock was holding them back from aggressive bad-loan disposals and renewed lending. It was the first central-bank foray into the buying of shaky risk-assets. The plan announced Sept 18 2008 by Paulson and Bernanke was the second, and the announced purpose is very similar: The central bank, by buying shaky assets from the banks, hopes to remove balance-sheet pressure on them, and thereby get them to return, as if by magic, to their traditional lending functions. The big problem being how to get the elected government to go along with what would otherwise look like a boondoggle among friends. (The fact that the Sept 18 date is the same in the two cases is surely one of those spooky coincidences; but the proximity to the half-year-end reporting date of Sept 30 probably isn't).

In the Japanese case, the BOJ move (which didn't require legislation, and was criticized by some as being quite limited) was seen partly as putting pressure on the Koizumi administration to itself become more aggressive in ending the lending logjam. Those who had been recommending aggressive and unconventional measures throughout this period were frustrated by the argument that there would be no political support for such measures. The BOJ move was supposed to trigger a follow-up program by the government, which however didn't come about. The point is that in general terms it was a case of administered central authority versus the elected government.

One of the things that was inherited from that experience, which was naturally studied by the Americans, was the focus on the question of how you obtain political support for this kind of bank bailout. You would need fear. But capital adequacy and questions of that nature are generally of a long-term nature and have a lot to do with accounting and reporting decisions, not normally the stuff of political hysteria.

By contrast, the interbank market, which in the US is the so-called federal funds market, has just the characteristics needed, because in addition to being the market where banks swap funds in order to stay ahead of reserve-ratio requirements (which have to do with liquidity, not capital requirements) it is also where banks settle their commercial transactions each day. So if people thought in some way that market were to fail, then it would indeed be armageddon, and people would do whatever you asked in order to restore the necessary "confidence".

This is only a somewhat educated guess, but probably what Bernanke and Paulson told the congresspeople during that frightening meeting on Thursday evening was a just such a story about the interbank market and armageddon. In the cold light of day, it would be remembered that when banks can't get other banks to lend them funds, there is always the central bank to act as lender of last resort, and then if there is a basket case, an orderly bank-liquidation. But don't forget that staff were excluded from that meeting...

This is a little sketchy, and partly based on what I remember from that period, but I think it is important to remember at least that there is a historical context for the whole idea of how you get an elected government to do something as raunchy-looking as buying bad assets from the commercial banks when the going gets rough. And that this includes the problem-area of building what you could call administered pressure on the elected representatives to do that. Logic suggests that at the very least, the drama of last Thursday wasn't something that just happened.


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