In the middle of September of 2008, a year after the subprime crisis broke, US government officials announced the imminent collapse of US financial markets that would lead to conditions similar to those during the Great Depression. The cause was that the lending channels in the economy were "clogged" with impaired securitized mortgage-backed assets on the balance sheets of financial institutions. The feared result is that non-financial business would not be able to fund productive activities that support growth and employment. They recommended a solution in which the US government would take impaired securitized mortgage assets off the balance sheets of financial institutions. However, it is far from clear that this would provide the relief sought.

The major problem threatening the stability of the US financial system is impaired risk assessment caused by the default of many mortgage-backed assets, yet it is not clear that removing them will make it easier to assess counterparty risk in short-term credit markets. But this should be the first objective of policy since these markets provide the basic liquidity support for financial institutions and presumably for the day to day production operations of business.

The new financial architecture which buttressed the new consensus in monetary theory was to have eliminated the possibility of a 1930s style business cycle by providing a more rational and efficient distribution of risk through the use of new risk-based capital requirements and new risk-specific financial instruments. The proof was the decline in the volatility of real variables such as growth and employment, as well as the reduction in risk spreads relative to risk-free government securities. It is clear that this system has broken down – instead of risk being transferred to those most able to bear it, it has been transferred to those most willing to receive income from bearing it. The major problem currently facing the US economy is the inability of those who have willingly accepted risk to bear it. As a result of the failure of financial institutions to meet their commitments to bear risk many have declared insolvency, been merged into other institutions or nationalized. This has created a generalized distrust of counterparties to any financial transaction. As Keynes taught, in these circumstances, the only possible way to quell disquietude over the creditworthiness of a counter party is to hold cash rather than lending it at interest if its return at maturity is uncertain. This is absolute liquidity preference, in which there is no interest rate that will offset the fear of failure of completion of the contract.

As Minsky, building on the work of Keynes and Irving Fisher pointed out, this leads to a process of liquidation of assets that creates debt deflation in which liabilities increase faster than assets can be sold to meet them. This process quickly produces insolvency and bankruptcy that spreads to the entire system. This is the Armageddon that Secretary Paulson and Chairman Bernanke have envisaged. The problem is that their solution starts at the wrong end, at the level of the devalued assets that are the result of debt deflation, rather than at the source, the absolute liquidity preference caused by the failure to confidently assess counterparty risk.

As Keynes noted, one way to solve the problem is to hold money, and one way to prevent this from producing complete disruption in asset prices is to increase the money to meet whatever the financial institutions demand. While this solves the problem of counterparty risk – a loan to the government represented by a dollar bill or a Treasury bill is riskless, it does not solve the problem of reducing the counterparty risk in interbank transactions. The government proposal aims to do this by OFFERING TO take impaired assets off the balance sheets of all financial institutions on the assumption that this will reduce the risk of non completion of contracts. But, there is no reason for this to be the case, as the plan will do nothing to replenish the reduction in banks’ capital that will be the likely result if the assets are purchased at market value. Given the difficulties in raising capital in current conditions capital can only be increased by further reduction in the size of balance sheets – less lending rather than more.

But there is a much simpler way to deal with counterparty risk that follows the pattern of organized derivative exchanges. The purchaser of a futures contract does not have to assess the risk of completion by the seller of the contract since the exchange acts as intermediary, monitoring risk and hedging risk by means of margin payments and position limits.

In the interbank market the Fed could play the same role as the exchange clearing house in interbank lending. This could be achieved by bringing forward the already approved permission for the Fed to pay interest on gross reserve deposits of member banks. Instead of holding Treasury bills to build liquidity, banks could hold deposits at the Fed. It would be the equivalent of the Fed issuing its own interest bearing notes. Since in normal circumstances, banks make loans and then seek to raise the required legal reserves to back them, the Fed would then have those resources available to lend to any member bank seeking additional balances. The counterparty on both transactions would be the Federal Reserve and banks would have no need to assess counterparty risk of the borrowers. The Fed guarantee would take the place of the $700 billion Treasury bailout, and existing regulatory supervision would take the place of counterparty risk assessment. This approach has an additional advantage. Existing Fed funds interbank market lending is unsecured, as is the private interbank market. Making the Fed the counterparty then eliminates the need for an the associate risks of interbank lending which would reduce short-term interest rates at the same time as it restores confidence in the interbank market.

In addition, in order to support bank lending to non-financial non-members of the Federal funds market, the Fed could return to the real bills doctrine, lending in full against commercial loans at the Funds rate. This would be facilitated by unifying the Fed funds rate and the Discount rate.

A supplement to this proposal would include support of banks' core deposit base by removing the limit on FDIC deposit insurance to match the unlimited guarantee recently given to money market funds. Those who argue that this might erode the deposits of money funds should remember that banks usually provide the backup credit lines for those funds. Additionally member banks should be allowed to borrow from the Fed without collateral and in unlimited amount to eliminate the possibility that larger banks could dominate the market for retail deposits at the expense of smaller banks. This should not produce any increase in risk to the government since Fed and other regulators already exercise control over lending exposures and capital ratios.

This proposal should resolve the problem of assessing counterparty risk and restore short term lending without requiring any government funding, pricing of assets or approval of a bailout package. All it requires is Congressional approval of the elimination of the cap on insured deposits of member banks and bringing forward the introduction of payment of interest on deposits, and the extension of Federal Deposit Insurance Corporation (FDIC) insurance to Fed deposits at member banks representing any unsecured lending by the Fed to member banks.

Once short-term markets are functioning, the problem of the recapitalization of sound banks and the resolution of unsound banks can be approached, preferably by the FDIC or an agency similar to the Reconstruction Finance Corporation (RFC). The problems of families facing foreclosure could be approached through an agency similar to the Home Owners’ Loan Corporation (HOLC). They need not however be formulated under the threat of imminent collapse of the financial system due to the collapse of short-term credit markets.

This would clear the way for policy to offset the decline in employment that will result from rationalization of the financial sector and support employment in the manufacturing and service sectors. These policies should be designed, as Minsky has stressed, in a way that minimizes the additional creation of financial assets and financial instability. His suggestion would be a government employment guarantee program since it provides income support directly and at the same time increases the production of useful goods. It would be particularly appropriate to resolve the infrastructure gap in the economy.

October 10 , 2008.