The shadow banking system

From Bill Gross of PIMCO, they manage $726 billion in assets

The loose regulation and financial innovation of the past 35 years have spawned what PIMCO’s Paul McCulley has labeled a “shadow banking system” where credit is composed on a keyboard as opposed to a printing press. Economic historians marvel at the ability of the Weimar Republic in the late 1920s to have printed paper money so fast that workers would lower their afternoon wages in a basket to waiting wives in order to front run rampaging six-digit inflation. Surely they could not have imagined shadow investment bankers and their minions spawning financial derivatives in the hundreds of trillions, far beyond the reach of central bankers and Treasury officials alike.

Gross concludes by saying the Fed will need to drop real interest rates to 1% to stave off recession, and is clearly worried about the economy. Yet the Japanese recession, which started for much the same reasons, was not solved by dropping interest rates to 0.25%.

John Robb comments

Unfortunately, there aren’t any control systems big enough or fast enough to compensate for behavior that exceeds acceptable boundaries — as we are seeing today. In physical systems this usually results in loads that exceed the tolerance of the system, things break apart, and the system crashes. It’s going to be interesting to see what happens in the financial system.

In you look at this in Marxist terms, then the ruling class should be manipulating and controlling the situation. But they’re not. The really scary truth, I think, is they are just as stunned by this as anyone else – and uncertain about what to do. This crisis of capitalism could mangle the lives of countless people everywhere, most of whom have  probably never even heard of CDOs or SIVs.

  • DJ

    The irony here is that Gross’s comments are self-contradictory: the creation of excess money through massive credit is inflationary pressure, not recessionary. But the neo-Keynesian economists currently in favor seem baffled at this: the result of massive debt and political manipulation of the economy results in stagflation, just as it did a few decades back. A 1% interest rate might save the functional economy from recession, for a while, but the dollar would be toast and the underlying problem would grow worse.

    The only way out as I see it is to RAISE interest rates, save the dollar, and take the economic hit for a while (as Carter did, killing his political career but ushering in decades of prosperity). Nobody will like that answer, except our children.

  • I agree, raising rates is what’s needed. But it’s a given the Fed will lower tomorrow.

    Gross also may have a vested interest in lower rates, depending on how many SIVs etc. PIMCO owns.

    Many of the more exotic financial instruments are based on borrowing short-term low interest money and investing it long-term, getting a higher rate. If short-term rates rise, they get squeezed.

  • the ruling class should be manipulating and controlling the situation…

    What if they are?

  • Eric Davis

    Does the 100 trillion number for this system come off the, 10 trillion in comercial paper, multiplied by the fractional reserve %?

    I’ve just been curious about that number, and where it comes from.



  • DJ

    “What if they are?”

    At first, I agreed with Bob that the neo-Keynesians are just clueless about reality. But the more I think about Thomas’s question, the more intrigued I am.

    I have always accepted the Capitalist party line that there is more wealth equality in a democracy because democracy promotes wealth equality. But as I look around the world, especially those places I have seen personally, it occurs to me that perhaps the contrapositive is true: democracy only works where there is relatively high wealth equality.

    If this is the case, then if you wanted to destroy democracy, you would promote greater divide between rich and poor. What better way than to disrupt the economy so it hurts those on the lower end?

  • While the ruling class will certainly try to exploit the current financial crisis for gain (well heck, I am too, I’m short financials) I doubt they want a collapse.

    That’s what’s been popping up on financial blogs for a few weeks now and is now in mainstream news. Serious questions about whether huge banks like Citi are solvent and what kind of systemic shocks are coming. Something which would hurt them too.

    That’s why they’re doing the SIV fund. To stave off disaster. Maybe.

    Not sure why destroying democracy would get them more money, and that’s their primary aim. (We’re talking capitalists here, not ideologues like BushCo.)

  • DJ

    But it was the ideologues (BushCo) who implemented the disastrous Keynesian economic manipulations: massive spending, decreased revenue, and tax breaks for the rich. The government’s insatiable thirst for credit helped raise market interest rates, making those sub-prime loans unservicable and ultimately crashing the real estate market (and the broader economy).

    Maybe BushCo did it by accident– yet it fits so well with their obvious goal of destroying our democracy (in favor of an “imperial” presidency) that if it wasn’t planned, it sure was serendipitous.

    I never credited BushCo with being all that bright, but when repeated “accidents” continually move the administration toward its unstated goals, I have to wonder whether I’ve underestimated them.

    (BTW, Andrew Sullivan suggests that Clinton would be the perfect president to continue this consolidation of imperial power– with Giuliani as a second “choice”– and I tend to believe him. Our democracy is at great risk these days.)

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