Ben and Hank Go to the Financial

Crisis
J. Bradford DeLong
Professor of Economics, U.C. Berkeley
Research Associate, NBER

delong@econ.berkeley.edu

September 23, 2008 DRAFT

If on the morning of Thursday September 18, 2008 you had set out to park
your money in a three-month Treasury bill, you would have found that the
interest you could get was—zero. Well, not quite zero: you would get $1
in interest over three months on a $1000 Treasury bill investment—an
annual interest rate of 0.4%. By contrast, if you had taken that $1000 and
put it into a major bank in a three-month certificate of deposit—a
CD—you would have been promised $14 in interest for the next three
months: an annual interest rate of 5.6%.

What does this big gap in interest rates mean? It means that even though
the bank has promised to pay you back your CD principal plus $14 in
interest in three months, people are not sure that the promise will be kept.
What if you show up in three months to get your money and the bank is
locked tight with the lights off—as in fact happened to people who
showed up at the London office of Lehman Brothers on the morning of
Monday September 15? If the bank goes belly up in the next three months
your investment is probably not a total loss: you will probably get three-
quarters of your money back, eventually. On the other hand, if the bank
goes belly-up it is probably because other very bad financial things are
happening and you really need your money: the $250 you will have lost
will be as painful to you as a loss of $500 in normal times.

So interpret the $13 spread in the interest paid over the next three months
on a CD vs. a T-bill as making investing in one rather than the other a fair

1
bet: there are, the market thinks or thought last Thursday, 26 chances in
1000 that a typical bank will go belly-up in a thirteen-week period: one
chance in five hundred each week, or the average bank goes belly-up
every ten years. By contrast, the normal level of this T-bill to CD spread is
much smaller: corresponding to one chance in 10000 that a typical bank
will go belly-up each week, or the average bank is expected to go belly-up
once every two hundred years.

Now no bank can survive for more than a month or two when market risk
is at such levels, Banks borrow a lot of money. They lend out a lot of
money at a slightly higher interest rate. They make their profits on
volume—on the amount of money borrowed and lent. Most of their loans
are long-term: their terms don’t change when market conditions change.
Most of their borrowings are short-term: their terms do change when
market conditions change. The high level of market risk and its rapid run
up from normal levels only a year ago last August means death to all
banks, and near-banks, and shadow-banks, and bank-like
institutions—unless the economic fever is broken and is broken soon.

“Good riddance!” you might say. “Death to all the banks!! Those
bankers—those smug overpaid suit-wearing bastards piously lecturing
others on financial responsibility while they collect $$$$$$$$$$$ and
wind up with fortunes in the $50 million or more range. Let their
institutions die! Let them go bankrupt! Let them have to get minimum-
wage jobs working at the Rubbermaid Plant in Winchester, Virginia!” But
that would not be wise. I could get behind the Winchester, Virginia
part—it has pros and cons—but the “death of institutions” part is probably
not what we want to do.

It is not what we want to do because right now we are relying on the banks
to cushion and manage a great economic migration. Eight million
American workers who used to have jobs in construction or in high-end
consumer services funded by free-spending yuppies using their homes as
ATMS and taking out home equity loans on the appreciation of their
residences have lost and are losing their jobs. They have to get other jobs
in other sectors. The natural place for them to go is our export goods and
services industries, and our import-competing manufacturing
industries—those are expanding rapidly right now as the decline in the

2
value of the dollar gains them market share from Americans and
foreigners who now find it cheaper to buy American. But our exporters
and our import-competing manufacturers need to borrow money to buy
buildings and install machines if they are going to expand. If Wall Street
freezes up, then they cannot borrow money—and the eight million
American workers don’t successfully complete their migration across the
economic desert to the waterhole. And then it snowballs. As their
spending drops, still more people in other industries that had relied on
their spending to create demand for the products they made lose their jobs.
Et cetera. Up until two weeks ago I was hoping that we could get out of
this without the unemployment rate ever going above seven percent (it’s
6.1 percent now) and with economists in the future having learned
disputes in cinderblock-walled seminar rooms over whether 2007-2009
really was a recession or a not-quite-recession. Now I am hoping that we
can get out of this without the unemployment rate going above eight
percent, and without their being a big as opposed to small recession.

That is the game that Federal Reserve Chair Ben Bernanke and Treasury
Secretary Hank Paulson are playing right now: try to keep the banking
system from freezing up; try to restore risk perceptions to normal levels;
try to keep finance flowing—so that we have a peak level of only eight
million unemployed in America next year, rather than fifteen million or
more. Try to accomplish this while keeping feckless financiers who are
responsible for the catastrophic failure of risk management that has gotten
us into this from escaping with too large a share of their ill-gotten gains.
And they have decided that they need help: permission to borrow an extra
$700 billion on the faith and credit of the United States of America and
then use that $700 billion to invest and buy mortgage securities. The hope
is that the economy will recover and risk perceptions drop so fast that the
government will make a profit on the deal—we did, after all, make a
healthy profit in 1995-96 on the government’s interventions during the last
Mexican peso crisis. The expectation is that we won’t see $100 billion of
that $700 billion back. But that is a social investment worth making: if it
does preserve the jobs of five million Americans during the next two bad
years, then we have about $50,000 x 5,000,000 x 2 = $500 billion on the
plus side. A 400% profit rate is a good deal.

3
Treasury Secretary Paulson has a plan: give him the $700 billion and trust
him. The big problem is that it is unlikely that he will still be Treasury
Secretary on January 21, 2009, and there is a 48% chance that the next
Treasury Secretary will be chosen by a man who thinks Sarah Palin is the
American most qualified to be vice president. Trust is OK, but verification
is better.

Senator Chris Dodd, Chair of the Senate Banking Committee, has the
responsibility for writing the bill to give Bernanke and Paulson the
authority they believe that they need. It’s a hard problem—protection of
the taxpayer’s interest vs. flexibility, punishing the feckless vs.
effectiveness at restoring the flow of finance, rescuing deserving
homeowners vs. rewarding those who used the housing boom to fund la
dolce vita. It’s exciting to watch, if you are an economist.