12 dimensional chess

NB: wrote most of this about a month ago, but nothing much has changed since then.

Well, we have the stress tests now, and I think the whole situation is marginally less bad than I thought when they came up with the idea.  Naturally, I don't for a second believe that the stress tests reflect the reality of the losses that will be taken.  The "most adverse scenario" is in line with any thinking person's (and in particular several thinking persons at the IMF) baseline case at this point.  I'd say there a 50% chance that the losses themselves could be worse.  And then you have the question of how much earnings will cover over those losses.  Right now, banks are back to making money hand over fist.  They turned a tidy profit trading in Q1 and the government has lowered their funding costs substantially.  The stress tests essentially had this trend continuing, which I think is dubious.  Finally, the whole operation is based around bringing the banks to a 4% equity ratio after losses and earnings -- ie. 25-1 leverage.  If this is what banking will continue to look like after the fall, we should all be scared.  Banks need to go back to being boring.  Those that aren't boring must be permitted to fail.  With 25 to 1 leverage, there's never a dull moment, unless you are referring to that twilight calm that overtakes a driver on the highway just as he is falling asleep.  In sum, I suspect these banks will be back at some later date.  The actual math of the stress test was the farce it was expected to be.

Why, then, have I learned to stop worrying and love the bomb?

Basically, because the charade was at least a plausible farce.  A lot of things in economics have to do with confidence, and banking is the clearest example.  So even making the banks appear solvent can prevent a further run on them.  It turns out that this required a lot more than keeping a bazooka in your pocket, as Hank Paulson put it, but in the end, a new president, a gigantic expansion of the Fed's balance sheet, and some jawboning about public private partnerships and stress tests seems to have done it.  If the government wants to prop up the banking system, it can always do this; modern banks are only really insolvent when the ATM stops working, and given that the government prints up the greenbacks that they spit out and only accept these as satisfying your tax, the worst that can happen is hyperinflation and social and political breakdown -- but at least no banking system insolvency.

Naturally, this brings me to the key observation.  You can always bail out the banking system.  But do you want to?  Basically, Obama has gambled that it was both politically necessary and economically viable to preserve more or less the same banking system he inherited.  I won't comment on the political necessity of this decision.  The guy is obviously a genius politician, I broadly agree with the direction he appears to want to take us in, and I don't see any reason to second guess his best judgement regarding how to get there. 

I am worried, however, that he underestimates the ability of the financial system to lobby to resist change, and in this underestimation, he has made a pact with the devil.  The pact may have been necessary to go anywhere at all -- again, I would have preferred a much more radical tack, but this is probably also why I'll never be a politician -- but that is no guarantee that it will work.  If he does not take the opportunity to really reform finance and reign in this giant parasite, then his new deal will leave him perpetually hostage to a group that now knows better than ever that they can bring the train to a screeching halt again anytime.  So propping up the banking system may have been a good step 1, but he better have a hell of a step 2 if he doesn't want to end up back at step 1 again in 4 years. 

For the moment, I'm willing to go along with the 12 dimensional chess analogy., and reason that certain key people and groups need to receive concessions in anticipation of their future support.  But I think we should keep in mind that the other team(s) are playing 12 dimensional chess as well, and they are not powerless or stupid.  The society of owners may have stumbled, but the are staggering quickly to their feet and if you don't knock them out soon, we will be back to the same old cycle where money-makes-influence-makes-money.