The Magazine

High Anxiety

We went from playing inflation-era Monopoly to playing depression-era Monopoly in mid-game.

Sep 29, 2008, Vol. 14, No. 03 • By LAWRENCE B. LINDSEY
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Third, once this threshold is met, it is doubtless a good idea to start reducing debt, particularly on credit cards and auto loans. These are about to get much harder to obtain as the credit crunch inevitably spreads from the commanding heights of the financial sector into the consumer credit arena. It will not be surprising to see the limits on credit cards lowered sharply, fees for holding cards rise, and auto loans tough to qualify for. The goal for households should be to be able to use credit cards for convenience only--paying the bill in full each month--and to have the ability to pay cash for larger purchases like a car.

Finally, for those lucky enough to meet the above criteria, where one deploys one's assets becomes a serious matter in the current environment. There was a saying in the 1930s that you should not have all your eggs in one basket. It meant spread the assets around. In the calm environment of the last few decades this dictum was rejected for the convenience of one-stop financial shopping. You might want to consult a financial adviser or at least inquire at the institutions where you have assets what the insurance limits are and under what circumstances your assets can be seized by creditors of the institution. This means asking questions about deposit-insurance limits, the assets backed by money-market funds, and whether your investments are in custodial accounts.

It is sad that we have to waste time in our busy lives worrying about things that people have not had to concern themselves with since the 1930s, but, frankly, aside from officials at the Fed and Treasury, the political leadership in both parties seems clueless about what is happening. Their inattention to these matters has contributed to our current mess, and this must change now.

First, President Bush should ask Congress to immediately remove the limit on FDIC insurance for transactions accounts at banks. This is central to protecting the payments system that allows the economy to function. Currently the cap is $100,000, which might seem like a lot, but barely covers the biweekly payroll and vendor costs of a company with a dozen employees. Once there is a commercial bank failure in which uninsured depositors see their accounts frozen, ripple effects will start to emerge that will end with a run on the banking system. Small and larger businesses alike will have no choice but to seek safe havens for their working capital, as will well-off individuals for the money they use to meet monthly expenses.

Second, politicians and regulators need to decide on the appropriate rules for reducing consumer credit lines once delinquency rates start to rise or market conditions make carrying credit card receivables--the amount of money you owe on your cards--difficult for banks. Currently these decisions are made by rules programmed into computers that were established when few thought we would ever see the kinds of credit conditions we are experiencing today. Prudent cash management by credit card companies will come into direct conflict with the credit needs of the household sector and the ability of the economy to sustain both spending levels and employment.

Third, and most important, policymakers are going to have to force us back from the current Depression Monopoly downward spiral toward the Inflation Monopoly arrangements. This is not as obvious a choice as one might expect. As recently as late summer Fed officials were expressing concerns about inflation being their main challenge, and politicians of both parties found it easy to oppose "bailouts" of seemingly well-heeled financial institutions, their owners, and their employees.

I realize that we risk rekindling all the imprudent behavior and excessive leverage that comes under the phrase "moral hazard" by trying to change the rules back. But continuing along our current track also involves morally dubious risks, like widespread unemployment and household and business bankruptcies. In this global economy, it also involves noneconomic risks that are reminiscent of the 1930s. Do we really want to chance the hundreds of millions of people who have joined the global middle class during the last decade dropping back into poverty? Do we think this can happen without geopolitical consequences? Despite some disappointing comments on the credit crisis, at least John McCain seems to understand the links between free trade and global security issues, something his opponent apparently fails to grasp.

The government's decision on Thursday to buy mortgage-backed securities--adopting the "full price for houses" rule--is a major step toward propping up the mortgage market and the financial industry. It was coupled with a variety of other rule changes that constitute a big step back toward "Inflation Monopoly." But as with any change in the rules there are going to be a lot of unintended consequences.

Start with the centerpiece of the plan, the purchase of mortgage-backed securities by the Treasury. This should help prop up prices, at least initially. But, there are some unusual aspects to the rule change. The government is purchasing assets from financial institutions that are still solvent, i.e., still playing the old game. Back in the days of the 1989 Thrift Bailout and the Resolution Trust Corporation, the government simply assumed the assets of any bankrupt institutions that the FDIC had to step in and insure. This time, ongoing businesses will have to decide which assets to sell and at what price.

In our Monopoly example, imagine you need cash and own Park Place but haven't been able to make a deal with the owner of Boardwalk. The government will take it off your hands, but for a price that is yet to be determined. One problem: You and the other players don't know if the government is going to turn around and auction the property off, allowing the player with Boardwalk to buy it. If so, that other guy might make a huge windfall at your expense and at the expense of the other players.

Also, this appears to be a onetime deal from the government. Should you sell now or take your chances in the market place? Say you own the three Yellows and have invested in placing three houses on each. You're solvent, but no one has landed on your houses leaving you cash strapped and disillusioned about the value of your investment. If you sell now to the government, they are probably going to give you something close to full value for those houses. But, property values are still depressed and the government now owns a ton of property and the financial paper behind it that could be dumped on the market at any time. So, if you don't sell to the government now while they are offering to buy at something close to full price, you could be forced to dump those houses in the market at half price sometime in the future. Thus, the government may have set up the incentive structure to take on more property, and more taxpayer risk than might otherwise have been the case.

Another example of unintended consequences has to do with the decision to insure money-market funds. Treasury officials probably thought they had to. (An estimated $180 billion came out of the funds on Thursday alone--giving some idea of how quickly a bank run can develop and how large the magnitude could be.) But, the Treasury is not insuring the uninsured depositors in the banks. Likely consequence: a run of money out of the banking system and into the newly insured funds. That's what happens when you change the rules suddenly.

To make things more complicated, the Securities and Exchange Commission placed a temporary ban on "short-selling," i.e., making a bet that the price of a stock would go down and also changed the rule that allowed companies to buy their own stock on the open market. They did this on a day when trillions of dollars of stock options came due, thereby manipulating the price of stocks higher. Serious questions are now being raised all around the world about whether or not U.S. markets are being politically manipulated.

Finally, it is far from clear that the Federal Reserve is going to be monetizing this process, or whether the financing is just going to be through more government debt in the market. If there is simply more debt, there will be little long-term increase in economic activity as the higher Treasury borrowing crowds out other investment. Continuing our Monopoly analogy, unless more money is pumped into the game through Free Parking or other devices and on a continuing basis, there will still not be enough money in the game to assure the profitability of all the houses and hotels that have been built. The odds are high that the Fed will ultimately print the money, and in volumes equivalent to giving players one of each kind of bill, but a formal decision on that still lies ahead.

It is very hard to play a game in which the rules change continuously. Once the novelty wears off, much of the fun will have gone out of the game as players will not know how to develop a winning strategy. This is even more true when the game is real and one's life savings is at stake. The government's ad hoc approach to the rules of the game to date--soon to be followed by investigations by state attorneys general and federal agencies and endless litigation--has probably permanently impaired the attractiveness of U.S. financial markets. That is a price we all are going to pay for decades to come. As we are all learning, Depression Monopoly is no fun to play.

Lawrence B. Lindsey, a former governor of the Federal Reserve, was special assistant to President Bush for economic policy and director of the National Economic Council at the White House. His most recent book is What a President Should Know .  .  . but Most Learn Too Late (Rowman and Littlefield).