A sovereign default is bad enough. But if the banks are stuffed with government debt, then a sovereign default brings down the banking system. Depositors lose their shirts, and the banks, who know how to distinguish good from bad borrowers, are shut down. A calamity becomes a catastrophe. And an economy with failing banks will be bringing in a lot less tax revenue and more likely to default.
This is what I call the “two drunks” model. The banks are one drunk, leaning on the government for guarantees. The government is the other drunk, leaning on the banks to fund its debt. But will the drunks be able to support one another and stagger home?
Read the whole post. Government, which purports to be our bulwark against financial fragility, is more likely the main contributor.
I do agree that the next big busts are government debt but I still hold that Italy and Japan go first here.
TBH, I still have not seen strong evidence that it was the government fault for the housing bust but the reality that capitalist economies are endangered by Minsky moments. I have read the evidence from free market economist but I find very directional (or fails to disprove the null hypothesis) that we had a bust and it must be the government fault.
1) I see housing bust coming from 60 year house bull run (w/ some minor drops), the Reagan Revolution that depended upon higher consuming spending and debt, and 10 years of strong economic growth from 1994 – 2004.
2) The reason why the housing grew after 2001 despite a recession, it was the area people making more money. Banks loaned more at higher values because it was very profitable and by 2004 they focused more on profits than loan quality. Bank made more money ignoring loan quality.
3) Yes there some society and government contributions (tax laws, American dream, minority borrowing. I find it weird the FHA never received a bailout.) but they still feel like pieces to the puzzle instead of the big picture.
4) Housing bust are quite normal for developed economies. (If you look at SoCal along with Texas had a small one in the S&L days.) Japan, and Sweden proceeded the US and other European nations had bubbles as well.
I still don’t see strong that it was the government fault here and the bust was most
It’s not my area of expertise but here goes. What is discussed in this blog entry is part of a larger set of phenomena that all are driven by some underlying driving factors.
1. Risk homeostasis. As you get safer, take more risks. Especially assume that the the government and large actors are “too big to fail or renege on promises of safety.”
2. Socialization of risk. Do your best to shift risk to others, meanwhile grabbing short term benefits for yourself. Do not worry excessively about scenario planning for “worst case possibilities.” Those things “can’t happen to us.”
3. Herd dynamics. Many decision makers are punished for mistakes that only they make while others behave otherwise, but if everyone is making the same mistake simultaneously they get a “free pass.” Practice the following excuse just in case: “No one could have known that…[insert your likely event that people wish simply isn’t going to happen anytime soon–flood, depression, war, family illness, unemployment, bad luck, natural disaster, etc]”.
1) There is probably a lot of we are too big to fail and the government can’t fail stuff in 2006- 2008 when reality was setting in. The main issue with this I need evidence that the largest banks were really thinking this 2001 – 2005 not when the number of foreclosures were increasing. Also, the worst players were the second tier organization, Coutnrywide, WaMu, etc that did not survive, not the biggest players.
2) Herd dynamics was definitely true with housing bust with banks and buyers. However, that does not prove government fault though. Herd dynamics happens in capitalism like the Japanese stock market in the 1980s or Dotcoms in US in 1990s or US railroads in 1890s. Also wasn’t Fannie and Freddie both identified as problem for not buying as deep (worst credit) in 2006 and earning less profit? I believe the herd in 2004 and 2005 acted they way they did because of most profits.
(The one aspect I would agree with is the ability of Fannie & Freddie to have higher leverage than other banks was a problem in which other banks out-competed with credit risk and not price.)
If push came to shove is there any asset class that:
1) The USG couldn’t take by force if it needed to.
2) That you could retain credible control and ability to trade that asset in a scenario where the USG doesn’t have the ability to take it from you.
I can’t think of many. Even ammo and beans would be pretty useless to me in such a case. I doubt that I could survive 5 minutes in Mad Max.
So treasury bonds are the best bet for any non Mad Max pessimist, while any scenario that would cause default would probably be Mad Max and this pointless to prepare for.
We may indeed be poorer then our paper assets say we are, but what better option is there.
That may be true for the USA, but the original post was in the context of Europe.
It’s entirely possible for a (smaller?) European country to have a sovereign default without condemning its citizens to Mad Max. And for Europe, it might be better to say that Italian banks should not hold Italian government debt.
This sort of reminds me of all the old companies who had their pensions funded with company stock. Then when the company went bankrupt, it took the employee pensions with it.