Brazen Tunneling and Inflation

May 29, 2009 2:45 PM

In most societies it is traditional to be somewhat sneaky in squeezing your shareholders or the government. You might set up a complicated transfer pricing scheme or perhaps you arrange for a family-owned firm to acquire assets on the cheap from the publicly traded corporation that you control. Or you could always arrange for the Kremlin to provide foreign exchange at a "special" price.

In the new United States, life is much simpler and bank tunneling considerably more brazen.

I'm starting a bank blotter. Here are some early entries, from the Wall Street Journal on May 27:

  1. We'll pay ourselves very high wages, rather than substantial bonuses (p. C3 in print edition). This is brilliant. These banks are supposed to be recapitalizing themselves, which means earning profits, and this is usually harder to do if you increase wages. Lower wages would mean the exit of employees at some of the world's poorest-run firms, entities consistently plagued also by the world's most blatant agency problems, but the banks simply assert that would be a bad thing.
  2. We'll use the PPIP money to buy toxic assets from ourselves and thus "participate in the upside" (p. C1 in print edition; reviewed here yesterday). In any decent society, this would set the red flags flying, but the banks have apparently lost all sense of moderation. Look carefully at (perhaps) the most fantastic angle here: These assets will be moved "off balance sheet," as if that does anyone any good. Remember that many such assets started off there and moved on balance sheet as the crisis developed. Come to think of it, the complexity inherent in the implicit conflicts of interest in this scam scheme would go over well in Russia.

What does any of this have to do with inflation? If you want the Fed to ever be able to tighten, you need a healthy enough financial sector; i.e., given what we now know about policymakers' preferences, banks in the "too big to fail" category better not be close to failing.

Big banks that pay higher wages will have less capital for the next round of difficulties. Banks that keep legacy assets close at hand will likely find out (again) why these loans and securities were called toxic. A weaker set of big banks will encourage the Fed to allow the yield curve to steepen, so monetary tightening happens later and perhaps too late to prevent inflation from taking off. Tunneling makes it harder for the Fed to tighten when inflationary pressures appear.

And if you think that inflation is not possible in the United States any time soon, please see my column on the New York Times' Economix blog.

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Simon Johnson Senior Research Staff

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