Banks, Bad Banks, Bad Bad Banks, Good Bad Banks, Congress and Chinese Banks...

Three bits in the WSJ today that make more sense together.

This one first: that a good bad bank is needed.

Then this on the fallacies that lie behind the idea that government spending is going to get us out of the recession: surprise, it's going to make things worse.

These tie in with this: if you think we have some bad banks, wait to you see what China has to offer.

So, let's start: the banking system is screwed. Not merely screwed, not merely "facing serious problems", but, and please pardon the vernacular, the banking system is truly fucked.

No one within the banking system (and in their right mind) wants to admit how badly the banking system has been damaged by the excesses of lending that Congress, in its infinite wisdom and ability to wreak carnage, made not only possible, but encouraged. The WSJ is pointing towards $800 bn in bad loans right now, I'd take that 50% higher if they were really being honest.

Banks are in the business of managing money, of being "financial intermediation", as the technical title puts it. They get money from savers and lend it to borrowers, and live off the difference between savings interest rates and loan interest rates. This differential, however, must be calculated to cover the one thing that banks are supposed to do well: risk management.

Well, the banks fucked up that one right and proper. Of course, they had help: the rating agencies were corrupted and the lonely controllers and loan portfolio managers who said "wait a second..." were stampeded by their colleagues heading out the door to make loans. That's because ways were found to move bank income from that interest rate differential (minus the risk management costs) to fees, with the loans sold off to avoid having to face the problems. In some ways the banks are not to blame: the government, after all, was telling them it would guarantee the loans (that's the reason for Fannie Mae/Freddie Mac's existence, after all) and gave them the opportunities to create financial instruments to sell these off.

By screwing up their risk management, banks forfeited their moral right to be saved. No bank out there - none whatsoever - is some sort of innocent victim of the subprime meltdown: all were negligent in their risk management. Period. Really, there are no exceptions.

So we have bad banks out there, banks that are bankrupt in all but name. What does bankrupt mean? The word was first recorded in 1533 and is latin-based, banca rotta: literally "broken bench", with banca, the bench, being the moneylender's shop, and rotta meaning "broken, defeated, interrupted", from the latin rupta, the feminine past participle of rumpere, to break. It became a verb in 1552.

A bankrupt bank is a broken bank, a bank that can no longer operate. It's a bank where the differential between savings interest rates and loan interest rates isn't enough. It's where fees fail to cover costs. It's a bank where the risk management strategy (such that there was one) has completely failed to prevent the catastrophic loss of value in the assets that made up the bank's securities.

So, what is to be done?

Here I agree with the WSJ (surprise, that, eh?). We need a good bad bank.

The principle is simple: we have a huge mess and we need to start cleaning it up, rather than letting the pile sit and fester. It's not a dry mess, some sort of heap that can be safely ignored, but rather it's a wet mess, one that has already started to stink, and the weather is getting warmer. If we don't want to have the financial equivalent of the garbage crisis that has made the Italian city of Naples almost literally unlivable, this has got to be cleaned up, dried up and deodorized. That is why we need the good bad bank, the bank that will deal with the problems, that will lay the sump dry, that will pump out the financial septic tank of the subprimes and stop the flooding.

Of course, that means that the problem has to be acknowledged and accepted, and Congress, in its infinite wisdom, steadfastly refuses to do so. They can't, politically: they caused the problem and are desperately seeking ways to deny that they smacked the collective banking system upside its head with a 2x4, after encouraging it to take off all the safety gear.

That leads us to Congress and the new budget from Team Obama.

The idea that government spending is connected somehow with a multiplier, that government spending can get us out of a recession, is based on a fundamentally mistaken view of how the economy works. If it were really true that government spending has a multiplier effect greater than 1, then all we ever need to do is have the government spend money. Private spending isn't needed, since you can generate growth simply by having the government spend, and by applying the growth rate of government spending to the multiplier, you can fine-tune the growth of the economy.

Nice try. Doesn't work in the real world. Why?

Because government doesn't add value in any sort of meaningful way. What we economists measure when deciding growth is value added in production, and GDP is nothing more than the value added to the economy. It's what is left over after everything has been sold, bought and paid for: fundamentally, it is the profits of the country.

Government spending has to be funded: it is done via taxes and bonds, with the occasional sale of assets. Both are taken out of profits, but given the fact that businessmen aren't dumb, these are factored into prices in such a way that the maximum amount of taxes and other financial costs - which government bonds affect - is carried by the customer, not the company. This can't be done completely - competition prevents this - but this is fundamental.

Hence government spending may have some beneficial effects as companies sell the government goods and services, but the government isn't spending "it's" money: it is always, always spending someone else's money.

Now, of course, this becomes political: can the government spend money in a meaningful way? My basic position, borne not merely out of political persuasion, but also years of living in DC, is that government spending is always sub-optimal when compared to private spending. There is simply no pressing need for government spending to be as effective as possible, which is always present in private spending.

Hence the multiplier effect on the economy will severely disappoint, as it always has in the past (and will always do so in the future). Professor Barro puts the multiplier at 0.8 at best, and that is for military spending alone.

In other words, Team Obama is trying to get us out of the worst recession since the 1930s by turning to solutions from the 1930s. That's not just dumb, that is stuck on stupid, seriously stuck on stupid. The greatest stimulus that the US economy could have would be to cut corporate taxes as low as possible - but not lower than zero - so that any spending is done efficiently, and not by the government.

And it remains, for me, simply flabbergasting that anyone could believe that governments spend money efficiently and productively in comparison to the private sector. Simply not true, as anyone who has ever worked for government will admit, if they are honest.

And it is efficiency that brings us to the third article: Chinese banking, which I fear will be the nail in the coffin of the current world economic system.

Chinese banks have a countercyclical pattern of lending: in boom times lending drops, in bust times lending increases. Normally bank loans increase during a boom and decrease during a bust period, reflecting demand for capital in an efficient system (called the market).

Banks in China remain firmly under control of the government there. The danger now mounting are the signs that China will generate a new credit bubble, one that they will not be able to control, as the non-performing loans are already large (and well hidden within the Chinese banking system), they will climb to the point where the Chinese banks, just as the rest of the world is starting to climb out of the hole that Congress dug, will have to take massive write-offs that will effectively break the Chinese banking system, just as the banking system in the US, Europe and, to a significantly lesser effect, Japan starts to climb out of that hole.

That would bring about a complete renewal of the crisis of the banking system at a time when recovery resources are exhausted.

We need a good bad bank, we need Congress to spend all of its time squabbling about ... anything, as long as they don't actually try to do anything, we need Team Obama to start actually listening to economists like Professor Barro, and we need the Chinese to clean up their banking system before it breaks.

In other words, we need a lot of miracles.