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The one-hoss shay

March 16th, 2008

The Fed’s bailout of Wall Street investment bank Bear Stearns has, unsurprisingly, been discussed in terms of the domino theory. A more appropriate metaphor is The Wonderful One-Hoss Shay . This was a carriage constructed on the theory that a system always fails at its weakest spot.

he way t’ fix it, uz I maintain, Is only jest T’ make that place uz strong uz the rest”.

On the Fed’s current approach, the system is unbreakable, provided that “too big to fail” protection is extended to every significant firm in the system. The result of this protection is that the kind of crisis where the failure of one firm leads to a cascade of failures elsewhere is prevented. But then

First a shiver, and then a thrill, Then something decidedly like a spill,– And the parson was sitting upon a rock, At half-past nine by the meet’n'-house clock,– Just the hour of the Earthquake shock!

–What do you think the parson found, When he got up and stared around? The poor old chaise in a heap or mound, As if it had been to the mill and ground! You see, of course, if you ‘re not a dunce, How it went to pieces all at once,– All at once, and nothing first,– Just as bubbles do when they burst.

  1. conrad
    March 16th, 2008 at 06:52 | #1

    Its great to see the American tax payer taking the risk for poorly managed companies. I wonder if they can ask for managing directory salaries also.

  2. March 16th, 2008 at 07:28 | #2

    I haven’t followed the news that closely. However if the Fed is bailing out this bank I hope the shareholders are being made to stump up some equity in return.

  3. David Allen
    March 16th, 2008 at 07:47 | #3

    Free markets hey? Drown the government in a bathtub before or after the bailout? This barbarian capitalism is as big a joke as Soviet communism.

  4. MontyA
    March 16th, 2008 at 09:47 | #4

    We have disposable horseless carriages that run on oil. The never ending supply is made possible by magic resources; no matter how much is extracted the reserves remain infinite. And we pay for it all with leveraged debt.
    The old alchemists have been transmuted, by the Rosetta stone, into … Economists.
    We are all masters of the universe now!. Let the good times roll.

  5. Socrates
    March 16th, 2008 at 11:01 | #5

    I admit I am no expert on finance markets so apologies again if this is a dumb question but..

    What about the cost of all these rescue packages? Should the ownership of those rescued transfer to government (a la Northern Rock) when public money is used? Is there a case for governments taxing financial institutions as a form of “insurance” against their likely cost to rescue? How much tax do all these firms pay, and how does it compare to what is being spent now? I thought that most fianncial duties had been lagely removed over the years, hence they paid little in fees to government. If so, then shouldn’t there be some emechanism for government/taxpayers to recover funds from them?

  6. observa
    March 16th, 2008 at 11:04 | #6

    We’re all freaking doomed with public servants rolling the printing presses everywhere http://www.atimes.com/atimes/Global_Economy/JC15Dj01.html
    I’m with Mogambo in the bunker trying to decide the right resource allocation of realtives, food, ammunition and gold. The true economic problem now.

  7. Socrates
    March 16th, 2008 at 12:16 | #7

    There is another article on this at the Economist. Tt includes a reference to yet more evidence of the unreliability of rating agencies:

    “Ironically, the intervention came a day after Standard & Poor’s, a rating agency, said that the worst of banks’ write-downs related to subprime mortgages—Bear’s biggest weakness—may soon be over. ”

    If Bear is the smallest of Wall Streets big-five trading banks, how exposed are the other four?

  8. Socrates
    March 16th, 2008 at 13:15 | #8

    Further to post 7, it is interesting to follow teh “chain-of-rescuers” to identify possible other at risk parties. Wall Street is not a charitable place. Who would try to bail out those at risk now? Those who they are likley to take under with them if they go down.

    For example, note this story in 2007 about Bear Sterns bailing out one of their hedge funds with a $3Bn loan:
    http://online.wsj.com/article/SB118252387194844899.html
    In fact it did later collapse and now Bear Sterns themselves are in the same boat. So why does JP Morgan Stanley feel so generous to loan Bear Sterns now? Sure the Fed are propping them up, but why should they be the one to do it?

  9. rog
    March 16th, 2008 at 13:27 | #9

    Every financial institution and investment house is exposed and it could take years before all those dud loans are exposed, in the mean time the taxpayer will foot the bill for political folly.

  10. Ikonoclast
    March 16th, 2008 at 14:54 | #10

    I can only say that more and better regulation of the system might have saved some of these problems. Given that the US and others are now in some difficulty I guess bailouts are to some extent necessary. Bailouts help the smallfry (ordinary mum and dad investors etc.) as well as the big fish. The Fed does have to try to prevent the whole system going belly-up.

    Prevention is better than cure of course. Let us hope this leads to some sensible re-regulation of the financial markets.

    Cripes! I must be feeling ill! I said something others might find almost reasonable! ;)

  11. Ian Gould
    March 16th, 2008 at 15:53 | #11

    Technically, of course, the Fed isn’t the US government – the Federal Reserve system is a series of regionally-based private banks operating under a Federal government charter.

    Furthermore, Stearns isn’t simply being given money – Morgan Stanley is being loaned money which it will then on-loan to Bear Stearns. The loans are secured against the assets of Bear Stearns (which admittedly include mortgage-backed securities of dubious value).

    The actual cost othe US taxpayer – if anything – is unlikely to be known for years until the mortgaged-backed securities are either sold, redeemed or written off.

    Judging by the example of the Australian state banks, the actual losses are likely to be much lower than the amounts currently being bandied about.

    But that might mean that the sky isn’t falling so it can’t possibly be right.

  12. melanie
    March 16th, 2008 at 16:19 | #12

    Is there a point at which the taxpayer can no longer afford to bail these guys out?

  13. Ernestine Gross
    March 16th, 2008 at 18:32 | #13

    Learning from history:

    http://assets.opencrs.com/rpts/RL31582_20030605.pdf

    http://en.wikipedia.org/wiki/Argentine_economic_crisis_(1999-2002)

    http://fpc.state.gov/documents/organization/8040.pdf

    Incidentally, Australia and the UK are one of the few countries that never defaulted on their borrowings.

  14. Ian Gould
    March 16th, 2008 at 21:46 | #14

    Melanie – not exactly.

    But there is a point where the inflation caused by running the printing presses (or by borrowing abroad in the case of the US) starts doing more harm to the economy than would the failure of the institutions being bailed out.

    That’s the conventional view anyway – Japan managed to pump stupefying amounts of money into failing institutions through out most of the 1990′s with seemingly little lasting harm to their economy.

  15. March 17th, 2008 at 06:15 | #15

    [socialism, anyone?] [democracy?][open government, and open commerce?] shhh!

  16. rog
    March 17th, 2008 at 07:45 | #16

    Ian is correct – the Fed does not use taxpayers money to fund its operations.

  17. rog
    March 17th, 2008 at 07:50 | #17
  18. smiths
    March 17th, 2008 at 10:10 | #18

    ian gould said
    “The actual cost to the US taxpayer… are likely to be much lower than the amounts currently being bandied about.
    But that might mean that the sky isn’t falling so it can’t possibly be right.”

    umm, great stuff, except its not true

    http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2002/03/22/000094946_0203070403315/Rendered/PDF/multi0page.pdf

    Borderline crises hit 44 nations. And on average, the World Bank economists found, “governments spent an average of nearly 13% of GDP cleaning up their financial systems” as a result of the bail-out programs they tried to implement.

    “Indeed, each of the accommodating measures examined,” they continued – citing “open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated (and thus initially inadequate or partial) recapitalizations, and debtor bail-out schemes – appears to significantly increase the costs of banking crises.”

  19. melanie
    March 17th, 2008 at 18:10 | #19

    #14 & 18. In the Philippines in the 1980s and in Indonesia more recently, servicing the largely private sector debt default cost as much as 44% of annual public expenditure. While not a lot of this came directly from tax revenues – but from public overseas borrowing – the cost to the taxpayers in loss of other expenditures was enormous.

  20. Ian Gould
    March 19th, 2008 at 00:45 | #20

    Smiths,

    Several points, firstly those averages are skewed heavily by several developing countries. See, for example, the table on page 3.

    You don’t have to have blind faith in the US banking system to beleive it’s probably better run and less corrupt than that of Suharto era Indonesia.

    Second and looking at the same chart, non-performing bank loans typically peaked at well over 10% of total lending. The US is nowhere near that and may never approach that level. If they do, it probably won’t be for several years.

    Third, head lien figures like 13% of GDP conjure up images of the great depression – but the costs of such crises are typically spread out over several years (or longer). Nor are those costs typically absorbed wholly out of current consumption – assets are written off, shareholders lose their capital; companies sell assets abroad, governments borrow the money, spreading the pain over the term of the bonds.

    Even a loss equivalent to 13% of US GDP – which I consider highly unlikely – isn’t going to result in the economic catastrophe some people here seem to be looking forward to.

    A more likely scenario is that US economic growth, goes mildly negative for a year or two followed by 5-10 years of below-trend growth. And that’s the pessimistic scenario.

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