The 'Inconvenient ' Truth

Dear Friends,

We all are/will be affected by the present financial/economic crisis across the markets of the world. Nobody knows how long will this last or how severe will it be. But are the responsible people doing their jobs correctly?

I thought I will share this fantastic article which explains not just the desperate measures of the 'central bankers' across the world but also offers a simple solution.

I'm surprised to see even most of the 'top economists' falling in the same panic-trap. This analysis is by a former finance minister of 'El Salvador' (yes, that's true) & it is spot on. Though his analysis is based on US actions, EU, UK, rest of the world central bankers/governments are doing something similarly stupid all in the name of 'saving the economy from deep recession'. What a sham. If you don't believe me, after reading this article, listen to any of the videos of 'Gordon Brown' on BBC/Youtube, (The one with Nick Robinson on BBC was a classic) on what actions he is taking to save the economy, and you will see what a fool he is. You will find various versions of Gordons across the world.

The 'inconvenient truth' is that we are in a deep hole (thanks primarily to our 'banker' friends) & the only way to come out of it is to expose & expel the culprits by letting them go down. This is exactly how Mr.JP Morgan sorted a similar scenario in 1909. He called all the bankers in a room, asked/forced them to reveal their exact position (on a piece of paper, remember there were no computers/mobiles then) and then letting the weakest ones go bankrupt. So Simple.

The irony is that one doesn't need to be an economist to come to this conclusion. It's common-sense!!!

Pradeep Kabra

Re: It's Time for Banks To Put Their Chips On the Table by Mr. Hinds in Wall Street Journal, 10-Oct-2008

The Federal Reserve injected $480 billion domestically and globally last week and it doubled the dose Monday, injecting more than $900 billion in one single day. Yet banks are still refusing to lend to each other, and when they do lend they charge a record-high risk premium—which more than cancels out any Fed rate reductions. At the same time, banks have absorbed about $1.5 trillion in cash from the Fed, more than twice the most likely loss in the mortgage markets (about $600 billion).

What we are witnessing is what economists call a rise in the liquidity preference, which was the main factor leading to the Great Depression. Investors aim to increase the share of liquid instruments in their total assets. For the banks it means they want to liquidate loans and transfer the proceeds to very liquid instruments.

This migration depresses the economy by reducing credit. The solution is not to keep on throwing money at the banks, which are inclined to hoard it not lend it. Rather, what is needed is stopping the skyrocketing increase in their liquidity preference and then lowering it. Doing that requires writing off the losses.

Imagine that you are playing poker with 10 people and that you learn that a minority of them is broke and would not pay you if they lose. You don't know, however, who the ones are who won't pay. Any rational card player would stop making bets until the true solvency position of each player is revealed and the bankrupt ones are expelled from the game. This is what is happening in the banking system—only worse, because in poker you would only fail to collect the pot if you played with an insolvent player, while in the banking system you would lose your bets if you lend to an insolvent bank. Liquidity preference will not subside until the losses are made explicit, written off and absorbed.

To achieve this you simply let the illiquid borrowers and their financiers go bankrupt. This is how financial crises were solved in the 19th century. The method was expensive because commercial banks are central to the operation of the payments system and their uncontrolled failure can cause enormous damage to the economy.

Yet continuing to play poker with failed players, also causes enormous damage. This is because the resources that could be used to spur economic recovery are not allocated due to lack of information. Worse still, resources are taken from the efficient to keep insolvent banks and companies operating.

The $700 billion rescue fund can be used for absorbing the losses and weeding out the failed players. By forcing the failed commercial banks to write off their losses then asking the owners to compensate for the losses with new capital. If they don't do it, the government takes over and recapitalizes the banks by purchasing the bad loans at their nominal value (as if they had not been written off). This no longer benefits the previous owners, who have already abandoned the table. The government then sells the banks, making a loss equal to the write-offs.

The $700 billion rescue fund should not be used to hide the losses in the accounts of the financial system by pretending that the government will recover all of them, as is the case now. This will only prolong the paralysis of the world economy, and ruin an otherwise winnable poker game.

(Mr. Hinds, a financial consultant and former finance minister of El Salvador, is the author of "Playing Monopoly with the Devil: Dollarization and Domestic Currencies in Developing Countries" (Yale University Press, 2006).)