[OPE] Prabhat Patnaik, "Excessive Liquidity Preference"

Patnaik seems to be arguing that US banks are insolvent because the total write-down of capital that will be lost exceeds the banks' "capital backing" (not quite sure what he means by the latter or to what accounting intervals he refers). I don't quite agree with that picture.

Simply put, a bank is insolvent at the point where it can no longer independently pay its bills. But this has very little to do in the first instance with the proportion of their equity, but with flows of revenue and expenditure, with yields, and with total assets and liabilities. There may be some banks which are technically insolvent, but others can potentially trade their way out of difficulty. The FT argued in regard to Lehman's that:

"There are two basic forms of insolvency. The first and more common is cashflow insolvency. This is when a company finds itself unable to pay its debts as they fall due. The second is balance-sheet insolvency, in which liabilities outweigh assets. Lehman's European operations fell into the first category. Like many global corporations, the bank swept all the cash from its regional operations back to New York each night and released the funds the next day. The Friday sweep had taken about $8bn out of London. Without cash, the business could not meet its financial obligations on Monday morning. A thriving business of more than 5,000 staff and investments worth billions of dollars was suddenly flat broke." http://www.ft.com/cms/s/0/e4223c20-aad1-11dd-897c-000077b07658.html

However, the FT definition of "balance sheet insolvency" is fairly meaningless as it stands. In a balance sheet reconciliation, assets and liabilities are - as Paul C. often points out - by definition equal. So balance sheet insolvency in the FT sense must refer to off-balancesheet items, or to the way assets and liabilities are valued. More critical is the proportion of liabilities to equity, as related to flows of company income and expenditure, and to yields.

Actually in its glory days, a company like Lehman's reportedly sold a range of around 4,500 different "financial products" linked to inflation rates, copper prices, hedgefunds etc. through a Dutch subsidiary Lehman Brothers Treasury BV, all with a speculative element. Investors bought these products presumably because of the higher yields on these more risky investments. For a (somewhat out of date) list of Lehman subsidiaries, see e.g. http://sec.edgar-online.com/2006/02/13/0001047469-06-001870/Section40.asp Lehman's, like many US banks and other financial companies, has been domiciled in the state of Delaware because it is a tax haven. Delaware has six different income tax brackets up to a nominal 6% or so. The state does not assess sales tax on consumers. Business and occupational license tax rates are said to be less than 2%. Delaware does not assess a state-level tax on real or personal property. Over 50% of US publicly-traded corporations and over 60% of the Fortune 500 companies are incorporated in Delaware, because of its business-friendly corporation law. http://www.corp.delaware.gov/aboutagency.shtml Franchise taxes on Delaware corporations supply about one-fifth of its state revenue. http://finance.delaware.gov/publications/fiscal_notebook_07/Section02/sec2page24.pdf Not accidentally, US Vice President Joe Biden is Delaware's senior senator (in Holland, people often think this is funny, among others because we have a non-profit funeral services company called DELA here).

The Kansas Reserve Bank notes that:

"Large banking organizations in the U.S. hold significantly more equity capital than the minimum required by bank regulators. This capital cushion has built up during a period of unusual profitability for the banking system, leading some observers to argue that the capital merely reflects recent profits. Others contend that the banks deliberately choose target capital levels based on their risk exposures and their counterparties' sensitivities to default risk. In either case, the existence of "excess" capital makes it difficult to observe how banks manage their capital levels, particularly in response to regulatory changes (such as Basel II)." http://www.kc.frb.org/home/subwebnav.cfm?level=3&theID=10601&SubWeb=10658

Mark Weisbrot points to the real problem though:

"The current economic problems are seen as overwhelmingly a financial crisis, when in fact there are major problems in the real economy that are dragging the economy into a serious recession. In other words, even if the problems in the financial sector are resolved, it would not prevent this recession from deepening." http://www.monthlyreview.org/mrzine/weisbrot300908.html

Companies and persons who loaded themselves with debt, on the supposition that they could trade low interest rates against high investment returns, become very sensitive to even small changes in final demand, and if final demand shrinks relatively or absolutely, it rapidly becomes impossible to sustain the high debt levels. But all that does, is initiate a global credit game of "shift the financial burden", where the strong force the weak to pay up. Being in a strong position means, that you don't have to pay, and can evade financial obligations. Being in a weak position means that you have to pay, whether you like it or not.

Jurriaan

Little Joe never once gave it away
Everybody had to pay and pay
A hustle here and a hustle there
New York city is the place where they said
Hey babe, take a walk on the wild side
I said Hey Joe, take a walk on the wild side

- Lou Reed, Walk on the wild side

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Received on Thu Apr 23 02:06:44 2009