Saturday, March 14, 2009

The Current Crisis: The Economic Underworld of Bankruptcy for Profit

A friend sends along a fascinating column from down under.

Australian columnist David Hirst reminds his readers of a paper written in 1994 by economists George Akerlof (husband of San Francisco Fed President Janet Yellen) and Paul Romer. The year of the paper is very important, since it is well before the current crisis. The paper is titled, Looting: The Economic Underworld of Bankruptcy for Profit and was published by the National Bureau of Economic Research.

Here's the abstract from the paper:

During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent - and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and they suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.

In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
Sound familiar? The current crisis is what Akerlof and Romer describe, to the nth degree. The current crisis was managed by Goldman Sachs, beginning with the shoot down of Bear Stearns and Lehman Brothers (Both Goldman competitors). The assets were picked over by these vultures (including GW's cousin). Then of course, the billions in "bailout" money was passed out. In many cases the Treasury still won't tell us who the money went to. While the top insiders paid "themselves more than their firms [were] worth and then default[ed] on their debt obligations." Cleraly, this has been bankruptcy for profit and near bankruptcy for profit, just as Romer and Akerloff described.

This part of the ongoing insider saga appears to be over, as Obama appears to have overplayed his "the world is coming to an end" shtick. The world is suddenly getting much better. We are now headed for the world stage and a major change in the world financial structure and a new world reserve currency. With the Financial Stability Forum (FSF) playing a key role. FSF is headed by Italy's central banker, Mario Draghi, who, naturally, is the former vice-chairman of Goldman Sachs International.

Geithner is still managing things stateside, but one has to wonder for how long. Hirst thinks he is a goner:
Treasury Secretary Timothy Geithner will be removed as soon as is seemly unless he can perform an economic miracle, something his past shows he is not remotely capable of.
As I have written before, if reports are accurate that Sullivan & Cromwell chief, H. Rodgin Cohen, is being vetted for a Treasury post, my bet is he will be the new designated man at the top of the Treasury, whose main portfolio will be to protect Goldman interests.


  1. Stan Liebowitz has decribed the current economic crisis as a "Train Wreck". Maybe we are talking about the wrong kind of wreck. Maybe it's a "Ship Wreck". For a brief history of "wrecking" see wikipedia.

  2. Good find. I think it's important to qualify the "lax regulation" component so that it is lax regulation within a system of otherwise overreaching control. We have a problem of loopholes, not free market economics.