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Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

U.S. Economic Developments and General Update

Monday, June 6, 2011


On Saturday, June 4, Bob Aliber presented the following remarks at the University of Chicago. His talk summarized his recent publishing and research activities, as well as providing an overview of U.S. Economic Developments, The Dollar, and Dysfunctional International Monetary Arrangements. In addition to being Professional Emeritus of International Economics at Chicago Booth School of Business, Bob is also a member of Ativo’s Advisory Board. 

Dear Members of the XP Class of 1986

Many thanks—you honor me with this invitation to speak to you at this reunion.
I hope that you will invite me to your second twenty fifth.

It’s been a busy year. One activity was the shepherd for four books in their final stages before they went to the printer. In November Stanford University Press published Your Money and Your Life, the second book on personal finance with the same title. Basic Books published a very different book in 1982, which was written in response to the shock when I realized that I “would die with money in the bank.” The theme of that book was the financial life cycle, wealth accumulates rapidly in the last ten or fifteen years of active employment—most middle class Americans will have a positive estate when the train hits. The genesis of the 2010 volume was that staff benefits at the University asked me to talk to retiring faculty about financial planning in retirement. This time the shock was the recognition that many of my colleagues from all parts of the university would have a much higher ratio of assets to income at the time of retirement that they had contemplated ten and twenty years earlier. These individuals wanted and needed help in wealth management. 30,000 or 40,000 individuals a year in the TIAA system retire each year, many of these people buy books; if I could capture ten percent of the market, I would have a modest annuity.

The book is consumer friendly, full of practical advice—when is renting a living unit preferable to buying and owning, the true costs of different types of insurance, the “best buys” in colleges, how to arbitrage the tax system. The chapter on bonds and stocks indicates why the conventional wisdom that the real rate of return on bonds is four percent and the real rate of return on stocks is seven percent overstates both real rates of return, much more so on stocks than on bonds. The chapter “Why Are There 10,000 mutual funds in the United States and only two and one half auto companies?” reviews the cons practiced by the firms that own these funds and why many mutual funds can be costly to your financial health. And when should you begin to take your Social Security benefits—62, the normal retirement age, or 70?

A great read, lots of practical advice, and a marvelous gift for children, friends, etc.

In February 2011, Palgrave published Preludes to the Icelandic Financial Crisis; the co-editor is Gyfli Zoega, a professor of economics at the University of Iceland. We had visited Reykjavik in June 2007 on the intuition that an asset bubble was underway; I spoke to ten or twelve economists in the central bank, the private banks, and the universities, and met Gyfli. In December 2007 Gyfli invited me to give a public lecture at the university on the financial market developments in Iceland—he more or less sensed that I had a strong conviction that the country was sitting on a massive asset price bubble. The lecture was in early May 2008. The situation was delicate; all the data suggested a massive bubble in stocks. (What I had not realized at the time was how much corruption there was at the highest levels of the banks.) There were several diverse motives for collecting these papers—the first was to provide an opportunity to summarize the model that I had been developing about increases in cross-border money flows to a country, increases in the value of the country’s currency and increases in asset prices in the country—either real estate prices or stock prices or both real estate and stock prices. (The attachment to this letter is my introduction to the Icelandic crisis volume.) The second was to provide a vehicle for the paper that I had written for the May 2008 lecture. The third was to ask why the IMF and the OECD completely missed the implications of the massive imbalances in Iceland; staff from both institutions visited Iceland once or twice a year. Another was to ensure that the papers prepared by Frederic Mishkin of Columbia University and Richard Portes of the London Business School were more widely available; both Mishkin and Portes had collaborated with Icelandic co-authors and concluded that the Icelandic banks were in good shape. The Icelandic Chamber of Commerce was the ostensible sponsor for both papers, but the Chamber was a front; most or all of the money came from the Icelandic banks. Mishkin and Portes “rented their names”. Mishkin testified that he received more than $100K for his role. (Okay, I’m envious.) Mishkin and Portes were either dupes or knaves.

One of my economist-banker friends commented “Darwin had to visit the Galapagos to see phenomena that he might have been observed in his backyard if England if they had not been obscured by a lot of clutter. And you had to go to Iceland in your hunt for a bubble and to identify its origin”.

In May 2011, Palgrave brought out the seventh edition of The New International Money Game. The first edition was published by Basic Books in 1972. The book—like many of us–has become heftier over the years. The seventh edition has five new chapters; three focus on crises and their antecedent bubbles. One new chapter “The Silk Road and the Sahara Salt Caravans were Globalization 1.0” is a dig at Thomas Friedman’s The World is Flat. Another new chapter centers on the Reverend Thomas Malthus, OPEC, Peak Oil, and the real price of energy in the long run.

Seventh editions seem like exercises in the vanity of authors. I will be lucky to earn a nickel an hour.

In late June 2011, Palgrave will publish the sixth edition of Manias, Panics, and Crashes. Charles P. Kindleberger had brought out the first edition in 1978, and the subsequent three editions. I inherited the book from Charlie, and brought out the fifth edition in 2005. Charlie was an “ideal” co-author; he died in 2002. My self-imposed rule was never to omit an important idea of Charlie’s, although his criticisms of Milton were toned down. Repetition was reduced, sentences were shortened, and the action in the sentences was moved toward the front end. Charlie was a “clipper”, lots of notes from newspapers, etc. One of the challenges was to combine his approach, which a friend described as “cubist”—Charlie would take an idea as the basis for a chapter, and look at it with from six or seven different perspective in different historical episodes. My approach in contrast was to develop an international monetary history of the last forty years, more or less beginning with the end of the Bretton Woods arrangement of parities for currencies.

The narrative is that there have been four waves of financial crises in the last thirty years; the first involved Mexico, Brazil, Argentina, Nigeria, Indonesia, South Korea, and six or so other developing countries in the early 1980s. Most of the banks in these countries failed, and the governments defaulted on their U.S. dollar loans from the major international banks. Several of the large U.S. international banks would have failed if the U.S. regulatory authorities had not shown “forbearance” toward the recognition of losses on these loans. Japan was the central country involved in the second wave of crises, although Finland, Norway, and Sweden in this wave. Most of the banks in these countries tumbled into bankruptcy and had to be bailed out by their governments. The Asian Financial Crisis that began in July 1997 involved Thailand, Indonesia, Malaysia, and then South Korea was the third wave, although the crisis in Mexico during the presidential transition at the end of 1994 was a prelude to this wave because the antecedents were more or less identical. Again the banks in most of these countries failed, Singapore is one of the main exceptions. The fourth wave of crises involved the Untied States, Britain, Ireland, Iceland and Spain—and Greece and Portugal.

Each of these waves of crises followed a wave of credit bubbles when the indebtedness of a group of borrowers increased by twenty to thirty percent a year for three, four or more years.

The term “bubble” is not popular among many economists, especially in Hyde Park, both because it implies irrationality and it challenges the view that “all the information is in the price”. But the term is descriptive of the pattern of changes in the prices of currencies and assets. Consider the pattern of cash flows between the lenders and the borrowers in the two or three years prior to several of these waves of crises. In the 1970s bank loans to the governments and government-owned firms in Mexico et al increased by thirty percent a year for ten years, and the external indebtedness of these countries increased by twenty percent a year. The increase in the annual flow of money to these borrowers automatically led to the appreciation of their currencies. The interest rates on these loans averaged eight percent, although these rates trended upward during that decade of accelerating inflation since they were priced off LIBOR. The money that the borrowers received on new loans was much larger than their interest payments on the outstanding loans. This pattern of cash flows was not sustainable, since the debt of the borrowers was increasing two to three times more rapidly than their incomes or GDPs. At some stage it was inevitable that the lenders would become more reluctant to extend credit; when the pace of the money flows to these countries declined, their currencies would depreciate. That depreciation might start slowly, and then cascade, since investors would be more reluctant to buy securities denominated in currencies that were depreciating.

The lenders had failed to ask, “Where will the borrowers get the money to pay the interest if we stop providing the money in the form of new loans?”

Bank loans for real estate in Japan increased at the annual rates in the range of twenty five to thirty percent in the second half of the 1980s —and real estate prices increased at about the same rate. Interest rates on these loans were six percent plus or minus. The loans were collateralized by real estate and hence did not appear risky.
But again it was inevitable that at some stage the lenders would reduce the rate of growth of credit for real estate—and then some of the borrowers would have to scramble to get the money to pay the interest.

In February 1997 a student brought a clipping from a newspaper about a real estate transaction in Hong Kong; the most expensive residential property on Victoria’s Peak had been sold by the owner of a department store in Tokyo to the owner of department store in Hong Kong. The story was intriguing. I flew to Hong Kong a few weeks later; a former student arranged a meeting with four individuals involved in real estate. The first question was “What is the rental rate of return?” The answer, “Three percent.” The second question was “What is the mortgage interest rate?” The answer, “Seven percent.” The third question was “How can you make money if you earn three and pay seven?” The answer, “The price of real estate always rises.” It was clear there was a bubble; I visited KL and Bangkok on the trip, and the same phenomena were observable.

The minimum condition to motivate or stimulate a bubble in a currency is that the rate of growth of the borrowers’ indebtedness is several times higher than the interest rate—and by extension, the rate of growth of the borrower’s income or GDP.

The second feature of the period is that the pattern of increases in asset prices induced by the money inflows was not sustainable because the pace of money inflows would inevitably decline. My analysis suggests that the increase in money flows to a currency when its currency is floating must inevitably lead to an increase in asset prices. This explanation was inspired by Keynes’ analysis of the transfer problem associated with post-First World War reparations; he asked what adjustments must both Germany and France make if reparations were to be paid. My variant is “How does an economy adjust to an autonomous increase in money flows from abroad?” One part of the adjustment story is that its currency appreciates, the story of the previous several paragraphs. The second part is that asset prices in the country must increase, since investors buy the currency as a necessary intermediate step before they can buy assets. The surge in asset prices is an integral part of the adjustment process, since the country’s imports must increase so that there is an induced increase in its current account deficit that corresponds with the autonomous increase in the capital account surplus.

The likelihood that these four waves of crises are independent and unrelated seems low. The competing view is that there is a systematic relationship about one crisis and the foundation for the next credit bubble.


Since the late 1990s, I have made three or four BFL presentations a year for Chicago Booth clubs, mostly in second-tier cities like Denver and Boston and Washington; the focus has been on developments in the U.S. economy and changes in asset prices, including the price of the U.S. dollar in terms of the Euro, the Japanese yen, and other foreign currencies. In December 1999 the statement was that there was a bubble in the U.S. stock market, that it would soon implode, and that the relative price of stocks and bonds “would change by eighty to ninety percent”. In February 2006, at the BFL in Denver, the statement was that there was a massive housing bubble in the United States, which would soon implode, and a recession would follow.

A brief detour. One of my minor passions is the language—the choice of words—used to describe international monetary developments. The press is full of chatter that the U.S. dollar is “weaker” or “stronger”. The dollar is the yardstick. As Gertrude Stein would have said, a yardstick is a yardstick and always 36 inches long; the lengths of different objects increase or decrease in terms of the yardstick. No one would ever say, “The yardstick is shorter or the yardstick is longer. The statement that the U.S. dollar is weaker is a statement that the Japanese yen and the Euro are stronger. Foreign currencies appreciate when central banks in Asia and Europe allow their currencies to strengthen, presumably because they are concerned that their inflation rates are too high; similarly these currencies depreciate when the central banks in these countries want larger trade surpluses as a way to increase employment and the growth rate. The unique U.S. role in international monetary arrangements is to provide global consistency; if all other countries as a group manage their economies and their currency intervention policies to achieve trade surpluses, the United States will have the counterpart trade deficit.

Or consider statements like “The United States is borrowing $250 billion a year from China” or “China is financing the U.S. fiscal deficit.” (Fifteen years ago, the rhetorical question was “Where will the U.S. Treasury get the money to finance the U.S. fiscal deficit if the Bank of Japan stops buying U.S. dollar securities?”) Consider the first of these statements, which suggests that President Obama and Secretary of the Treasury Geithner went to Beijing, kowtowed, and said “President Hu, we want to borrow $250 billion.” Obviously, this didn’t happen. The Peoples Bank of China buys $250 billion of U.S. dollar securities each year because China wants a large trade surplus with the United States, and the PBOC can’t find any international reserve assets that are more attractive than the U.S. dollar. The President and the Secretary of the Treasury would be very happy if China bought more U.S. goods and fewer U.S. dollar securities. China “finances” fifteen or twenty percent of the U.S. fiscal deficit, but its protectionist trade policies cause ten or fifteen percent of the U.S. fiscal deficit because they induce lower levels of employment and profits in the U.S. industries that produce tradable goods.

In the 1990s much of my attention was on the impact of market developments in Japan on the U.S. economy. Subsequently the attention has been on global imbalances, and most recently on the flow of money from China to the United States. Something dramatic happened in China soon after the advent of the twenty first century; in the previous several decades China’s imports and its exports were more or less in balance. About 2001, China’s exports surged and it developed a very large trade surplus because of the combination of its massive barriers to imports (trade protectionism) and the reluctance to allow the yuan to appreciate (currency protectionism). China’s trading partners, primarily the United States, have adjusted to the surge in China’s trade surplus and in the counterpart money inflows from China.

The prelude to the U.S. financial crisis in September 2008 is more or less comparable to the prelude to the crisis in Iceland. The sharp increase in money flows to the United States meant that the U.S. dollar had a higher value than it otherwise would have had, and induced an increase in prices of U.S. assets, especially real estate. (The U.S. experience differed from the Icelandic experience in that the Fed was following a low interest rate policy as the U.S. economy recovered from a modest recession, while the Central Bank of Iceland followed a high interest rate policy to dampen the inflationary pressures associated with the surge in household and business spending.)

My story for the U.S. real estate boom is very different from the popular explanation in Washington, which centers on the misbehavior of the banks, greed, the compensation arrangements for bankers, the failure of the regulators, the corruption of the credit rating agencies, etc. These explanations are arguments by association; none can explain why the banks and the regulators began to misbehave in 2004 or 2005.

Currently the United States has an output gap of four or five percent of GDP, say $800 billion to $1,000 billion, a trade deficit of $700 billion, and a fiscal deficit of $1,300 billion. The U.S. trade deficit is the autonomous factor and led to the large output gap; much of the U.S. fiscal deficit followed from the U.S. trade deficit. The primary cause of the U.S. trade deficit is that China and a number of other Asian countries follow export-led growth policies; they maintain undervalued currencies to ensure that they have significant trade surpluses.

If the value of the U.S. trade deficit is taken as given, the United States can have a low unemployment rate only if it has a large fiscal deficit, or a sub-target level of household saving, as in the 2003-2007 period. If measures are adopted to reduce the U.S. fiscal deficit while the U.S. trade deficit remains more or less unchanged, household saving and household income will decline.

Each decline of $100 billion in the U.S. trade deficit will lead to a decline of $250 billion plus or minus in the U.S. output gap and a decline of $60 billion to $70 billion plus or minus in the U.S. fiscal deficit. The appropriate target is ensure that the ratio of U.S. Treasury debt in the hands of the public, now about $10,000 billion, is more or less constant as a share of U.S. GDP; since U.S. GDP increases by two and one half percent a year, a fiscal deficit of $250 billion is consistent with a stable value for this ratio. The difference between the increase in the U.S. Treasury debt and the U.S. Treasury debt acquired by the public represents the U.S. Treasury debt acquired by the Federal Reserve and the various U.S. government trust funds; together the Fed and these funds own about one-third of the Treasury debt and appear likely to acquire about $400 billion of debt in the next several years, especially if the output gap declines. If the U.S. trade deficit declines to $300 billion, the U.S. fiscal deficit will decline by $200 billion. Now add $250 billion, $400 billion, and $200 billion for a total of $850 billion. The difference between $1,300 billion and $850 billion is $450 billion, which is a minimum estimate of the necessary change in the relationship between federal taxes and expenditures.

President Obama wants to increase tax rates paid by those who earn more than $250 thousand a year to their 2000 level, which would bring in $20 billion a year. Great. Either the taxes paid by the great middle class will increase, or the expenditures that benefit the great middle class must be reduced.

One of my major concerns is with the “declinists”; many misunderstand the nature of economic growth in the global economy. The United States was in a unique position at the end of the Second World War, Germany and Japan were in shambles and lacked the capacity to be competitive. It was inevitable that the U.S. share of world GDP and world exports and world auto production would decline as these countries rebuilt their productive capacity. The Japanese growth experience in the 1960s, 1970s, 1980s, and 1990s conformed with the “Andy Warhol theory of economic growth” that I had developed in the early 1990s. Japan grew rapidly for three decades and then it experienced “the mother of all asset price bubbles” in the 1980s; once the bubble imploded, its growth rate has been modest.

Now the declinists focus on China, whose GDP is projected to exceed U.S. GDP in 2019 or 2020. Maybe.

The Chinese growth performance has been very impressive, both visually and in terms of the data, several hundred million people have moved into the middle class. In the early 1980s, DengXiaoPeng went to Tokyo and returned with the Japanese model for financial regulation. Set low ceilings on the interest rates that banks can pay household savers, and set modestly higher ceilings on the interest rates that banks can charge borrowers. Recognize that the demand for credit at these low interest rates will exceed the supply, and authorize the mandarins to tell the banks who should be the first to receive credit.

Moreover Deng invited the multinational firms from the United States, Japan, Europe, and Taiwan to invest in China because he saw that they would distribute goods sourced from Guanchou and Xiamen and Wuhan through their supply chains. China’s exports increased at a rapid rate.

The counterpart of the surge in living standards is that hourly wages have increased at a rapid rate and are now much higher than wages in Vietnam and Indonesia and Bangladesh and India. These multinationals are shifting their sourcing to the lower wage and cost neighbors. Chinese manufacturers then will be without the institutional arrangements for export sales, and their brand names will be unknown. The Chinese are entrepreneurial, and eventually the gap will be closed.

China has a massive real estate bubble, much larger than the one in the United States; perhaps twenty percent of the homes constructed in the last three years were acquired as investments, many remain unoccupied. The combination of low nominal interest rates and increases in the inflation rate—the government says five percent, taxi drivers say ten percent—has encouraged real estate investment. The government is tightening interest rates to curb the inflation, which is likely to puncture the housing bubble. Auto sales are slowing, and as they slow further, the excess capacity throughout industry will become evident. Then the very high savings rate in China will be a curse, and the problem of excess supply will become dominant. Chinese firms will seek to increase their exports. The dilemma for the United States is whether to give priority to maintaining the openness of the international systems despite the provocations from the second largest economy or whether instead to give priority to maintaining the growth of the domestic economy.


The primary item is completion of a new book on international monetary developments of the last forty years that will bring together several themes. There are at least five innovative ideas in this book.

One focuses on the surge in the supply of international credit—money “sloshing” across national borders. There is a massive amount of credit parked in international banks that can be readily accessed for funding loans in various countries. Money from this pool money sloshed into Mexico and Brazil in the 1970s, into the Nordic countries in the late 1990s, in the emerging market countries in the early 1990s, and into Greece and Portugal and Ireland in the last several years. The supply of money in this global pool is massive relative to the economies of these small open economies. Much of the money in this pool has resulted from the large payments imbalances; the countries with the payments surpluses have parked some of this money with the major international banks.

A second chapter develops the narrative about the transfer problem process, and its application to a number of countries beyond Iceland. In some countries including Greece and Portugal the recipients of the money inflows were the governments, which financed much larger fiscal deficits; in these cases there was a credit bubble but not an asset price bubble. (In these cases, the supply of assets and the foreign demand for these assets are increasing at about the same rate.) In Ireland and Spain the recipients of the money inflows were the domestic banks, which increased their real estate loans; the increases in the demand for real estate led to increases in the prices. Jon Johnsson in Iceland sold his Icelandic securities to American and European investors; Jon then had to decide what to do with the money received from the sale. He could either buy more consumption goods or he could buy other securities from other Icelanders. And he could do both and he did both. His purchases of other Icelandic securities from other Icelanders, including Sven Svensson, meant that Sven had the same choice—the money became like the proverbial hot potato. Asset prices increased. What I want to explain is why asset prices increased so much more rapidly in some countries than in others.

A third chapter focuses on the role of the changes in the prices of currencies on the domestic economies when currencies are not pegged. One of the vivid debates when I arrived at Chicago in 1965 was whether a floating exchange rate regime was preferable to the IMF arrangement of adjustable parities. Milton Friedman and then Harry G. Johnson at Chicago, Gottfried Habeler at Harvard, Fritz Machlup at Princeton, developed a powerful set of arguments in support of a floating exchange rate arrangement. Consider some of the assertions advanced by the proponents of floating in the 1950s and the 1960s. One was that changes in currency values would be small and continuous, rather than large and abrupt, as when Britain devalued in November 1967. Another was that because changes in currency values would track changes in the differences in national inflation rates, the scope of overvaluations and undervaluations would be smaller than when currencies were pegged. A third was that countries would be able to follow independent monetary policies; under the adjustable parity system, foreign countries could not allow their interest rates to differ by more than a smidgen for interest rates on U.S. dollar securities. Milton et al asked, “Would you prefer the prices and incomes in various countries adjust so the established parities could be maintained, or would you prefer that the currencies adjust so that the required adjustment in prices and incomes would be smaller?” When the question is posed in this way, the answer is obvious–let the currencies adjust.

The data on changes in the values of currencies and cross-border money flows challenge the preview of floating that was presented in the 1960s. The changes in values of currencies have been much larger than they were when currencies were pegged; at times, currencies have depreciated by sixty or seventy percent. The scope of overshooting and undershooting has been much larger than when currencies were pegged. The proponents of floating suggested that changes in currency values would be like a buffer and provide insulation to countries from a shock that might originate in their trading partners; instead these changes in currency values are a shock; although perhaps more appropriately, the changes in the cross border money flows constitute the shock.

Some of the assumptions in the arguments developed by the proponents of floating were—let’s say faulty. They believed that the shocks would develop in the goods market, and that the cross-border money flows would dampen the movement in the value of the currencies. Instead many of the shocks have developed in the money market. One reason some of these proponents preferred a floating currency regime was that central banks would be able to follow independent monetary policies; however they neglected to ask, “If central banks follow independent monetary policies, what will be the impact of changes in monetary policy on cross border money flows and the value of currencies?” There have been many more shocks when currencies have been floating, and most of these shocks have been monetary.

Another feature of this period is that the variability in cross border flows of money has been much larger than when currencies were pegged. These flows are responsive to changes in the difference in anticipated returns on domestic and foreign securities. But why should the changes in these differences be larger than when currencies were pegged. One plausible story is that the cross border movements of funds have an impact on the rates of return, perhaps because they trigger an economic boom as a result of the positive wealth effect.

One feature of the thirty years since the early 1980s is that the trading revenues of the large commercial banks, the investment banks, and the hedge funds have soared; the rate of increase in these revenues seems many times larger than the rate of increase in cross-border trade and investment. At the same time, competition and technology have led to a decline in bid-ask spreads. One story that reconciles the previous two sentences is that the volume of assets and securities that these firms trade has increased, as if the increase in the quantity of items traded is larger in percentage terms than the decline in revenues per trade. An alternative story is that the much greater volatility in the prices of assets and securities has encouraged momentum traders who follow the cliché that the “trend is my friend.” These revenues of the traders reduce the incomes of the non-traders who buy and hold these assets and securities. Still waiting for an insight on this problem.

The narrative about the role of the changes in currency values may evolve into two chapters.

One chapter is directed at the source of the increases in the supply of credit available for the purchase of real estate in various countries. There are two different models—the increase in the supply of credit in Japan resulted from domestic monetary expansion. The increases in the supplies of credit in Ireland and Spain resulted from money inflows to these countries—the central banks in Ireland and Spain effectively are branches of the European Central Bank. The increase in the supply of credit to the United States was primarily a result of money inflows.

Consider Lehman, not a bank. Did Lehman create credit or was Lehman a channel that allocated credit to subprime borrowers in Southern California? Lehman is a financial intermediary; Lehman could not extend credit to these subprime borrowers unless someone else was willing to extend credit to Lehman. Similarly Fannie Mae and Freddie Mac are financial intermediaries; they could extend credit to buyers of real estate only to the extent that they could induce someone to buy their IOUs.

One part of the chapter on the credit allocation process will deal with “bailouts” and the moral hazard problem—although this might be a separate chapter. I have in draft an “interview” between Congressman Barney Frank and Walter Bagehot, editor of the Economist from 1861 to 1877 and author of Lombard Street, 1873; this interview was observed on C-Span 10 at 4AM six months ago. The Bagehot doctrine is to lend freely but at a penalty rate, the rationale is to ensure that a liquidity crisis does not escalate into a solvency crisis. My supposition is that Bagehot would say, “Do Not Lend to an Insolvent Institution—Like a Lehman.” Yet the argument for lending to an insolvent firm is identical to that with lending to an illiquid firm that is solvent, namely to ensure that the scramble for liquidity leads to a decline in asset prices, so that the solvency of some institutions that previously had been well capitalized is threatened. When Lehman failed, the bankruptcy court began to dispose of its assets, however one of its great assets, its knowledge of the creditworthiness of various borrowers, was lost.

The failure to “save Lehman” is the single most costly error in U.S financial history. Saving Lehman would have involved dilution of its shareholders so that each share was worth a nickel. Fuld would have been banished to Inner Siberia, the directors would have been placed in the stocks in Central Park, and some legal stratagem would have been invented to void employment contracts. Saving Lehman would have meant that the bondholders and those with counterpart risk would have been made whole. The argument for saving Lehman is the cost of externalities of failure. Public credit needs to be promoted when the private suppliers of credit are hiding in the trenches. The U.S. Government is the ultimate vulture investor; TARP has made a profit on its bank loans, and it appears as if the Fed and the Treasury investments in AIG will prove profitable or nearly so, even though AIG was forced to sell some jewels of assets in distress circumstances.

Another chapter involves the role of international banks and the competition for market share among them. When I was in Brussels in February, I learned that the last surviving Belgian bank, Kreditbank, had extended extensive loans to the Irish banks and to banks in Poland. What advantage does Kreditbank have in lending to Irish banks and Polish banks? Kreditbank had “excess capital” that it did not want to use in competing for a larger share of the Belgian market for bank deposits. Banks headquartered in many different countries have excess capital that they do want to use in their domestic markets. Something is happening that we do not fully understand and is captured by Chuck Prince’s remark “You have to keep dancing as long as the music is playing.” Maybe, but where is the music coming from? Presumably the music refers to the increases in the supply of credit. The banks that sit out some of the records conserve their capital relative to those who rush to capture market share, and then are burned when asset prices tumble. The puzzle is that the bankers never ask, “Where will the borrowers get the money to pay us the interest if we stop lending them the money in the form of new loans?”