Citi and the Slow Boiling Frog

By Kyle-Anne Shiver and Lee Cary

The slow boiling frog theory is on display with the U.S. Government’s prospective ownership of a significant share of Citigroup, Inc.

Here’s one definition of the theory:

The boiling frog story states that a frog can be boiled alive if the water is heated slowly enough — it is said that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will never jump out.

At least one economist smelled the frog boiling back when the water was still lukewarm. Francis X. Cavanaugh wrote The Truth about the National Debt: Five Myths and One Reality (Harvard Business School Press, 1996). He was the first executive director and CEO of the Federal Retirement Thrift Investment Board. And, according to the book’s jacket, “He was also an economist and the senior career executive responsible for debt management policy advice in the Treasury Department.”

Thirteen years ago Cavanaugh wrote this:

There has been a dramatic increase in this federal share of total U.S. credit, from an average of 17 percent of net credit market borrowing in the 1960s to 27 percent in the 1970s and 41 percent in the 1980s. In the five years 1991-1995, the average was an extraordinary 71 percent. (The peak was 89 percent in 1992.) We have reached a point where most of the securities available to private investors in the United States are direct or indirect obligations of the federal government. What does this mean? Are the credit markets in the United States now largely nationalized…federalized…socialized, if you will? Does anyone care?”…The federal government’s takeover of the U.S. credit markets in recent years must be the biggest and quietest takeover in the country’s financial history. (p.77)

Did anyone care? Cavanaugh did. And he predicted an outcome we’re now living:

The major concern with the shifting of credit risk from the private sector to the government is the loss of market discipline usually relied on to maintain the quality of credit. Private lenders, who are normally bound to exercise due diligence through careful inspections, appraisals, and credit investigations before extending credit, have less incentive to be so diligence when the government is guaranteeing them against loss. The old rules of ‘know your customer’ and ‘know your collateral’ are relaxed. To an increasing degree the ‘customer’ is now Uncle Sam, not the borrower, and the ultimate ‘collateral’ is the Treasury’s taxing power, not the property that is supposedly securing the loan. A resulting decline in the quality of credit could lead to defaults and weaknesses in the national financial structure during periods of economic stress. (p. 83)