Ripple Effects

by hilzoy

From the NYT:

"Cities, states and other local governments have been effectively shut out of the bond markets for the last two weeks, raising the cost of day-to-day operations, threatening longer-term projects and dampening a broad source of jobs and stability at a time when other parts of the economy are weakening.

The sudden loss of credit, one of the ripple effects of the current financial turmoil, is affecting local governments in all parts of the country, rich and poor alike. Washington has shelved a planned bond offering to pay for terminal expansion and parking garages already under construction at Dulles and Reagan National Airports. Billings, Mont., is struggling to come up with $70 million more for a new emergency room. And Maine has been unable to raise $50 million for highway repairs.

“We really are in terra incognita here,” said Robert O. Lenna, executive director of the Maine Municipal Bond Bank, which helps that state’s towns and school districts raise money. He said he had worked in public finance for 34 years and had never before seen credit evaporate so completely.

Maine had already begun some of its road work when the bond markets stopped functioning, so now it is scrambling for bank loans to keep the dump trucks rolling. If money does not start flowing soon, Mr. Lenna said, Maine will have to cancel some of its road and bridge projects."

Meanwhile, in Massachusetts:

"The most immediate need is $1.3 billion in quarterly payments that are scheduled to go out to cities and towns next week. Municipalities use the money to fund everything from teachers to trash collections.

Cahill said it appears likely that cities and towns will get their local aid payments - preventing layoffs and cutbacks in municipal budgets - but he said he has had to jump through a complex set of financial hoops to make it work. Cahill and other state officials characterize the borrowing maneuvers as common ways to make payments before all of the tax revenue comes in. But the state usually is not this strapped this early and facing interest payments this high.

The state yesterday borrowed $51 million in a short-term loan from investors, at an interest rate of 6 percent for a practice that normally charges 2 percent interest. In order to make local aid payments, the state still needs to borrow up to $349 million in similar loans before next week. State officials fear a similarly high interest rate.

"This stuff is unheard of," Cahill said. "It's like going to the loan shark for money.""

Heading into a recession is the worst time to cut back on projects like these, which provide people with good jobs, and can work to keep the economy going. The Federal Government can run a deficit, but most states cannot. So just at the time when people need these jobs the most, they end up having to cut back. It makes problems with the economy worse, when keeping these projects going would help to make it better.

Comments

[shah8]

The bailout plan was not really designed to relieve the credit market so much as not make it *worse*. It certainly does not directly target the aspects of the credit market that funds government projects.

Remember, all it really does is give a capital injection to major banks, mostly. Not the smaller banks, and certainly not any of the other sources of credit. While it *could* help the local governments do stuff, eventually, local governments are under a pile of bad circumstances and many are becoming worse credit risks along the lines of Birmingham or San Fran exurbs.

Lastly, theres a not so small chance that it could fail.

[bedtimeforbonzo]

From the Financial Times, addressing the non-action of Congress risking a Great Depression:

"Against this dire background, what is one to make of the failure of Congress to ratify the plan? It is both understandable and a gross error.

"It is understandable because the use of taxpayer money to buy so-called 'toxic' mortgage-backed securities from the greedy fools who created the crisis is hard to tolerate. It is also understandable – even creditable – that those Republicans hostile to 'socialism' do not want to bail out the undeserving rich, at least before an election. It is understandable, too, because, for reasons I put forward last week, the plan is not convincing. It is designed to deal with a problem of illiquidity in what seems certain to be a growing crisis of insolvency, particularly as house prices fall and the economy continues to weaken.

"Yet the rejection is grossly mistaken because the resulting ruin will hurt the weak and destroy the legitimacy of the market economy. The plan is indeed flawed. But failure to ratify it is unlikely to convince anybody that something better will be forthcoming. It will convince them, instead, that the US is choosing to be impotent. At a time of such fragility, when the insurance offered by government is most indispensable, this is the worst possible message. It is a pity Mr Paulson did not choose another plan. It is a pity, too, that a former titan of high finance was charged with bailing out Wall Street. Yet it was still a mistake to reject the plan. It was necessary, instead, to build upon it.

"What now? The first effort must be to find a plan that Congress can pass. It is quite possible to find one that protects the taxpayers’ interest better, by insisting on full reimbursement, after assisted companies return to health. Buying preference shares, as Warren Buffett did in Goldman Sachs, would be a good way to do this.

"Second, it seems likely that a number of significant financial institutions will find it hard to fund themselves in coming days, as their share prices weaken and interbank lending is frozen. Central banks must make every imaginable effort – and a few unimaginable ones – to make sure liquidity needs are fully met during this period. The Federal Reserve may find itself having to rescue additional institutions. So, alas, be it.

"Third, Europeans (among whom I include the British) must recognise they are in the same boat. In times of such peril, even a small cut in interest rates by the European Central Bank and the Bank of England would send a helpful signal. It is now most unlikely to prove inflationary.

"None of what is happening is easily palatable. The need for a rescue is hard to swallow. The emergence of bigger and even more complex financial behemoths – all too big to fail – is a harbinger of crises to come. Yet, while one must consider the long-run implications of how a crisis is resolved, one must resolve it first.

"Franklin Delano Roosevelt famously said that 'the only thing we have to fear is fear itself.' In truth, the economic processes unleashed by the bursting of the housing and credit bubbles are real. But fear is also a danger. When confidence collapses, a market economy cannot function. It must now be restored.

"The problem is not lack of knowledge of how to do this: we know how to recapitalise and restructure damaged financial systems. The problem is lack of will. Government must start to show it is in control of events. In the twilight of a failed US administration, that may seem far too much to ask. Winston Churchill, Roosevelt’s partner, said: 'The United States invariably does the right thing, after having exhausted every other alternative.' The alternatives are now exhausted. It is time for politicians to do the right thing."

Listening to David Gergen last night decry the lack of leadership thoughout this whole mess, the CNN commentator and advisor to several presidents, as Anderson Cooper always reminds us, he mentioned that, in times like this, it would not be beyond the pale for the President of the United States to call an emergency session of Congress -- one in which the President address, like a State of the Union.

This may sound like grandstanding. But when the stakes are a potential Depression or a long painful recession -- and if we haven't already been in one of those, I'd hate to see a real one -- I'd call it the President doing his job.

Of course, our President is George W. Bush, who would have been laughed at by Churchill or FDR.

The Senate, where they sometimes say cooler heads prevail, are taking their turn at-bat tommorrow. Unfortunately, two of its members are running for President -- many others for re-election.

Seeing how they don't make leaders like Churchill or FDR, politics may still gobble up principle and America's best interest.

[bedtimeforbonzo]

"Lastly, theres a not so small chance that it could fail."

Then what do you propose?

[Warren Terra]

Shah, I'm certainly no expert, but my understanding was that credit crunch effects such as those Hilzoy cites are precisely what the bailout is meant to address. The problem here for these towns is largely psychological: no one really thinks that the risk of those towns no longer being able to collect taxes has dramatically increased, so they haven't suddenly become much riskier bets as short term borrowers. But confidence in general is low, and as a result lack of liquid capital is a problem in the markets, so they're paying a premium. The hope is that the govetnment being seen to Do Something will alleviate this. Whether the bailout will work I really do not know; but problems like the one Hilzoy cites suggest that it may indeed be necessary that Something be Done.

[ThatLeftTurnInABQ]

This issue really started up last year and then became critical many months ago - I'd have to dig in the archives at the usual suspects on the econ blogs to show the timeline, but here's just one example from March 2008: Auction Bond Failures near 70 percent.

I remember reading back in the spring about the complete failure of the auction system that state and local govt.'s were using to sell their bonds at what at the time were considered to be reasonable rates, and even before then the collapse of the monoline insurers (AMBAC, MBIA) spelled doom for the muni bond market, and the city of Vallejo, CA was something of a canary in the coal mine showing what the future holds for local govt.s all over the country.

This well has been dry for some time, in other words. Nice to see the NYT finally getting around to noticing the problem. If you don't mind my beating a dead horse here, if you want to read about what the NYT will be publishing articles on next Jan, read the econ blogs now.

My bet would be on exploding interest rates as a result of which debt service will consume 25-30% of the US Federal budget for Fiscal Year 2010 and possibly earlier into FY 2009, forcing cutbacks of 50% or more in all non-essential US Govt programs.

[Nell]

Meanwhile commercial paper is experiencing no such effects.

[radish]

It makes problems with the economy worse, when keeping these projects going would help to make it better.

Is this is supposed to be an argument for purchasing toxic paper from big banks so that they will give better rates to municipalities, or an argument for federal purchase of municipal bonds?

Because if it's the former, could you please go to the extra trouble of explaining why buying up toxic paper would be better than, say, adopting what Stirling Newberry has so charmingly labeled a "too sick to lend is too sick to live" policy?

I love you dearly hilzoy, but please entertain the possibility that both you, and the experts on whose opinions you are relying, are mistaken about the best way to proceed. Remember the commercial paper Paul Krugman was so worried about the other day? Turns out non-finance sector commercial paper is doing great. And apparently smaller community banks are doing pretty well too. Much better than the bigger banks.

Does that not at least make you wonder whether a trickle-down solution is the best way to handle this?

[ThatLeftTurnInABQ]

Seeing how they don't make leaders like Churchill or FDR, politics may still gobble up principle and America's best interest.

btfb,

I too am hoping for something better from our leadership than what we've gotten thus far, but before you pass judgment in haste or beat them down too far using comparisons with great leaders of the past as a cudgel, please consider this proposition:

It is far easier to lead out of a crisis than it is to prevent one from occuring in the first place. Neither of those two mid 20th cen leaders who you just cited prevented a crisis. Nor did Lincoln for that matter. Instead they took terrible circumstances already at hand, far worse than what we face now, and worked up from there.

Even the greatest of our leaders have worked within the framework of what their fellow citizens were willing and able to do, and this is by human nature a rather different thing once everyone recognizes that a point of crisis has been reached, than it is beforehand.

[Gary Farber]

"but before you pass judgment in haste or beat them down too far using comparisons with great leaders of the past as a cudgel"

I'd also like to note in passing, that for all their immensely admirable qualities and achievements, both FDR and Churchill were immensely flawed individuals. One could write volumes on their mistakes and character flaws.

There are so many, it's hard to know where to begin. Churchill was by drunk as a skunk much or most of the time, starting in the morning, was crippled by depression ("the Black Dog") much of the time, was infatuated with his own ideas, many of which were terrible, was racist, imperialist, wanted Britain to hang onto India forever, and so on and so forth. FDR also had lots of bad ideas, wasn't terrribly honest, ran a chaotic and disorganized White House, swinging back and forth between the contradictory advice of one advisor over another, picked economic numbers at times by what he thought would be "lucky," had a long-term affair behind his wife's back. and so on.

I admire the hell out of FDR, and am fascinated by Winston, and find much to admire in him, along with much to criticize, but they were terribly human humans, not giants on pedestals.

Some perspective should be kept.

[Gary Farber]

"It is far easier to lead out of a crisis than it is to prevent one from occuring in the first place. Neither of those two mid 20th cen leaders who you just cited prevented a crisis."

Flipping around on my previous argument, I'll note that Churchill spent the Thirties warning anyone and everyone who would listen to him of the dangers of Nazi Germany and Hitler, and advocating rearmament and confrontation. It's just that he was seen as a crazy right-wing militarist long past his time, and was listened to by no one in power. But it's quite arguable that if he had been listened to, the crisis of WWII in Europe might possibly have been largely averted.

I got no outs for FDR on preventing the Depression, to be sure.

[sidereal]

Heading into a recession is the worst time to cut back on projects like these

If only there were 700 billion dollars that were politically in play with which the federal government could use to provide liquidity to these municipalities. .

Oh wait, let's buy a bunch of questionable mortgage securities with it instead!

My theory of this whole process is this: the shakeup has been accurately described (see Roubini, et al) as a chain of dominoes. First the real estate market goes, then the worst tranch of MBS, then all of the MBS, then credit default swaps, then interbank lending, then commercial paper, then commercial lending, then muni bonds, then consumer lending, etc.

The proponents of the current bailout have argued that we must stop it at the current domino. We have to prop up Goldman Sachs and Wachovia and Citibank. Because if they fail, the next domino goes. I argue for letting another domino go. Maybe two or three more dominos. If you've got 700 billion dollars ready to provide liquidity, you can pick your spot. I'm extremely suspicious of the influence that the financial industry has in encouraging saving the current (their) domino.

[Warren Terra]

To second Gary, I love the heck out ot Churchill as a writer and as a fantastic historical figure, but pretty much every decent thing he did in public office was in service of war. His positions on labor and economics were especially retrograde, including brutal and thuggish strikebreaking and advocacy of adherence to the Gold Standard in the teeth of the Great Depression.

[ThatLeftTurnInABQ]

and was listened to by no one in power. But it's quite arguable that if he had been listened to, the crisis of WWII in Europe might possibly have been largely averted.

Gary,

Sometime when nothing interesting is going on, remind me to reopen this conversation. That's a well known counterfactual history which personally I consider to be wildly implausible, but this probably isn't the best time to engage in threadjacking.

[Gary Farber]

"That's a well known counterfactual history which personally I consider to be wildly implausible"

Oh, yeah, I don't think there's any way to make it come out as plausible without postulating a bunch of unlikely differences in that alternative universe, but, sure, might be fun to discuss.

Maybe Alternate-Churchill had super-hypnotic mind-control powers!

In general, I'm fond of alternative histories/counter-factuals, but in most cases things tended to happen the way they did for reasons not easily flippable.

"His positions on labor and economics were especially retrograde, including brutal and thuggish strikebreaking and advocacy of adherence to the Gold Standard in the teeth of the Great Depression."

And dismissed Gandhi as nothing but a fakir.

[Warren Terra]

C'mon, Gary, get the quote right, it was a half-naked fakir. But at least Gandhi had the last laugh, no thanks to Churchill.

[hilzoy]

"Is this is supposed to be an argument for purchasing toxic paper from big banks so that they will give better rates to municipalities, or an argument for federal purchase of municipal bonds?"

No; it's meant to be an observation about the effects of all this.

And I am, very much, mindful of the fact that I could easily be wrong. Also, that because I'm looking at the question 'which of the alternatives available is best?', where availability is constrained by the politicians we actually have, and one factor that matters is the time in which each alternative might be enacted, I do not get to consider some of the options I might like best. (E.g., the Swedish model, passed today.)

[TJ]

I'm going to suggest that if the short-term commercial paper, municipal paper, and small business loans are truly frozen then it might actually make sense to funnel bailout money directly to them, cut out the middlemen, and not count on a trickle-down effect.

[SamChevre]

Note also that part of the problem is that with falling housing prices and falling incomes, many municipalities and states have very shaky finances. It's not just a credit market problem; it's also a "lousy risk" problem.

[Megan]

I am terribly afraid that California waited a couple years too late to put in high speed rail. I worry that we missed the opportunity.

On the other hand, labor is about to get cheap. Perhaps we'll return to building large projects by hand.

[Hartmut]

Worked well for Hitler (using men instead of machines for construction works).
This is intended as a neutral statement not a reductio ad Hitlerum.

[John Thullen]

"You never give me your money.
You only give me your funny paper,
and in the middle of negotiations,
you break down"

[Bernard Yomtov]

Still, there are stories like this.

[OCSteve]

The best explanation (in layman’s terms) of this whole mess I’ve yet read is here. It’s soup to nuts and very understandable. (via Insty) Not that understanding it better is any solace. Still, I highly recommend it.

[Andrew]

Calculated Risk noticed that the monstrosity coming out of the Senate is loaded with absurdities like this:

SEC. 503. EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN.

(a) IN GENERAL.—Paragraph (2) of section 4161(b) is amended by redesignating subparagraph (B) as sub301 paragraph (C) and by inserting after subparagraph (A) the following new subparagraph:

‘‘(B) EXEMPTION FOR CERTAIN WOODEN ARROW SHAFTS.—Subparagraph (A) shall not apply to any shaft consisting of all natural wood with no laminations or artificial means of enhancing the spine of such shaft (whether sold separately or incorporated as part of a finished or unfinished product) of a type used in the manufacture of any arrow which after its assembly—

‘‘(i) measures 5⁄16 of an inch or less in diameter, and
‘‘(ii) is not suitable for use with a bow described in paragraph (1)(A).’’.

(b) EFFECTIVE DATE.—The amendments made by this section shall apply to shafts first sold after the date of enactment of this Act.

[liberal japonicus]

That sounds like it was designed to get a specific person's vote, and I'd be really interested if that were a representative or a senator.

[hilzoy]

OCSteve: that is a good summary. One additional point: I think it's wrong to say that the problem with mortgages was mostly about the teaser rates, etc. In general, the standards for writing mortgages went out the window, in ways that made no sense: e.g., not requiring documentation of your ability to repay the loan.

I don't know that this is true, but I suspect that part of the reason for this was that the market for mortgage-backed securities created a demand for mortgages. If you've got some mortgages, you can make a profit from slicing, dicing, and reselling them, regardless of whether the mortgage itself is any good -- so long as no one is checking too carefully.

It's the only explanation I can think of for the ways in which people were making loans in, say, 2006: that they wanted to make mortgages for some reason other than people paying interest on them, and eventually repaying them.

[bedtimeforbonzo]

Gary and LeftTurn:

I went to bed just after posting my comment upthread, so it was just now that I enjoyed reading your comments on Churchill and FDR.

It's worth noting that both Churchill and FDR both could give a good speech -- perhaps a necessity in being a great modern-day leader (or at least being a great communicator).

Obama's oratory ability has given him a leg up on the competition ever since he started running for president and should serve him well if he makes it to the White House.

[OCSteve]

No disagreement there hilzoy. The teaser rates were just part of that. Once they created the market for mortgages, they needed a steady supply of morgages…

[Gary Farber]

"It's worth noting that both Churchill and FDR both could give a good speech -- perhaps a necessity in being a great modern-day leader (or at least being a great communicator)."

Churchill started off with a stammer and a lisp, and only through dint of endless practice grew into a skilled speechmaker.

Some tips from him on speechmaking, and how he dealt with his speech impediment.

One bit:

[...] No opportunity to rehearse was overlooked, even while taking a bath. As he got into the tub he would start murmuring. Story has it that the first time this happened his valet asked, "Were you speaking to me, sir?" "No," came the reply, "I was addressing the House of Commons."

Don't we all?

[Gary Farber]

The Senate just passed the economic "rescue" bill, lit up like a Christmas tree, 74-25, btw.