Month: September 2008

This is one of the queries I receive, in varying forms, every day.  Did policies such as the Community Reinvestment Act significantly worsen the housing bubble and the subsequent collapse?  Basically not, although in my view these were bad policies for other reasons.  They contributed to our current problems by only a small amount and of course these policies have been around for a long time before the housing bubble ever got started.  Here is one back-of-the-envelope debunking of the "diversity recession" idea.  Matt Yglesias links to some other debunkings.

You can, however, cite the general obsession with extending home ownership as strong evidence that putting Democrats in charge does not suffice to solve our regulatory problems.

Only polite comments will be left standing…

Steve Randy Waldman says yes:

I would support a standalone act authorizing the Fed to pay interest
on deposits immediately. I would prefer that Congress impose limits on
the quantity of deposits on which interest can be paid, to limit the
risk and interests cost to taxpayers, but that limit could be quite
loose for the moment. This approach has the advantage of getting
liquidity into the banking system far more quickly than the Paulson
Plan ever could have, and drawing a clear line between the liquidity
and capitalization aspects of the plan. It could be implemented
immediately by passing the one sentence Section 128 of the Paulson Plan
in isolation (although again, I’d prefer to muck it up with a limit on
the quantity of paid deposits).

Freed of its balance sheet constraint, the Fed might consider
injecting funds into the banking system by purchasing a diversified
portfolio of holdings in money market funds that trade in commercial
rather than government paper. This would help relieve the stresses in
the commercial paper market very directly, and reduce the likelihood of
a disorderly adjustment in nonfinancial commercial credit markets.

On a different tack, here are some very good ideas from Paul Light, an expert on bureaucracy.  And did you know that the FDIC currently has the power to guarantee short-term interbank lending?  The Paulson plan was in fact quite slow, so maybe its failure will force us to look for other and better options.

The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis.  Since Congress doesn’t have to vote for something called "a bailout," it can give Paulson and Bernanke more operational freedom than they would have otherwise had.  The American economy is in recession for two years and unemployment does not rise above eight or nine percent.

The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls.  Margin calls cannot be met and the NYSE shuts down for a week.  Hardly anyone can get a mortgage so most home prices end up undefined rather than low.  There is an emergency de facto nationalization of banks to keep the payments system moving.  The Paulson plan is seen as a lost paradise.  There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag.  The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands.  In the very worst case scenario, the Chinese bubble bursts too.

I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure. 

Megan McArdle piles on:

…what works in the banking system of a small economy does not
necessarily work in a large one.  For starters, no offense to the
Swedes, but very few other countries are affected by what happens in
their economy.  One family, the Wallenbergs,
indirectly controls something like 30-40% of Sweden’s GDP.  Even now,
the Swedish financial system is considerably less broad and complex
than that in the US; it’s not a world financial center.  And in 1992,
everyone’s financial system was a whole lot less complicated than they
are now…

Possibly the biggest problem with this plan,
among many, is that Sweden is essentially able to command the labor of
its bankers; they have relatively few alternatives without starting
over in a new country and a new language.  American government has no
such leverage.  Yes, the folks in the mortgage departments royally
screwed the pooch, but running a major bank is not something you can
hand over to a GS-17.  Nor is it a job for academic economists. 

And,
of course, the political ramifications in the United States are very
disturbing.  A small homogenous country with a parliamentary system and
a lot of social capital invested in the government is going to do
better at nationalizations than we will.  The fractious structure of
the American legislative system means–as we’ve just seen–that huge
amounts of political maneuvering and log-rolling will go into the
running of any national banking system.  Imagine the banking system run
by the Department of the Interior.

…The problem with
the Japanese system (or at least, one major problem) is that for
political, social, and career reasons, banks kept pouring money into
zombie firms, trying to salvage the bad loans of a decade ago.  Is a
nationalized banking system less or more likely to do this than a
private one, in America?  I imagine any banking head, appointed
or career civil service, would get a lot of calls from Senators and
congressmen demanding that the bank prevent companies in their
districts from going under.

There’s lot of talk in the blogosphere in favor of the Swedish plan, but not much consideration of its drawbacks. 

Money market trouble was the trigger, and it’s back. The direct
response was a $50 bln insurance fund, not in place yet. How about $200
bln in insurance, with a 15-minute turn-over for enrollment? Give the
FDIC a green light – already backed by Treasury, so no legislation
needed. Put everything in place that can be done without legislation
and that directly addresses the issues that confront us, instead of
issue that are behind other issues. Financial firms will need to worry
about staying in business, but they won’t have to worry about
liquidity. Moral hazard is a lesser concern.

The big unfixable thing is that the government teased a hungry market
and then jerked the bacon away. Can’t fix that now, but there are other
approaches to the problems we have.

He is a commentator over at calculatedrisk.blogspot.com.  My personal, oversimplified rule of thumb is that as long as trading continues The End of the World has yet to come.

It’s also worth considering the new equilibrium.  If things do not totally tank right now, Paulson and Co. truly have zero credibility — for better or worse — the next time they claim that some particular policy action has to be done.

The TED spread is high, the T-Bill yield is low, banks are disappearing, etc.  It sounds grim and it is grim.  The "bright side," if I may call it that, is that the financial sector really does need to shrink.  It is doing so at an accelerated pace.  That is one problem from having so many derivatives markets but it is also their virtue.  There may be speculative swings in price but when reality arrives you can’t run away from it.  And a high TED spread can be a good thing too, forcing banks to shrink or consolidate or shed assets.  Bank consolidation raises profits and allows retained earnings to finance activity in the former losers.  If there is any consolation, this is not Japan of the 1990s, which was the original worry of many people.

The bumps may yet destroy the sled, but what appears to be bad news can in fact turn out to be good news.  Stay tuned…

Paul Krugman, Brad DeLong, and Matt Yglesias are all endorsing the Swedish plan for partial bank nationalization.  Maybe it’s better than what we’ll get (I haven’t read through the latest draft), but I don’t think they are addressing the weaknesses of the idea.  Namely:

1. Solvent banks don’t need to be nationalized.  Insolvent banks should be shut down.  Maybe they’re mostly insolvent, but that is second-guessing market prices just as much as Paulson’s view that bank assets can be bought on the cheap.  The implicit view is that current equity markets are overvaluing these banks.  (It is complicated, however, because current equity prices are not independent of the government plan and there can also be hovering in the neighborhood of insolvency.)  An alternative proposal, of course, is to reveal which banks are solvent and which are not.

2. There is much talk about taxpayers participating in the upside.  First, bank ownership is probably not an efficient way of redistributing wealth (is it what you want for Christmas?).  Second, Greg Mankiw’s friend scored a telling point:

…we
would all be better off if high schools taught the Modigliani-Miller
theorem. MM implies that the price of the asset (again,assuming the
auction gets it right) will adjust to offset the value of any warrants
Treasury receives. In this case of a reverse auction, imagine that the
price is set at $10. If Treasury instead demands a warrant for future
gains of some sort, then the price will rise in the expected amount of
the warrant — say that’s $2. Then the price Treasury pays for the
asset will be $12. Some people might prefer to get $12 in cash and give
up a warrant worth $2 in expected value. Fine, that’s a choice to be
made. But the assertion that somehow warrants are needed is simply
wrong.

I haven’t seen a good response.

3. Swedish governance is in many ways of higher quality than American governance.  It involves lower transactions costs, more social unity, and it is more inclusive of many different interest groups.  For one thing, the concentration of wealth in Stockholm makes it harder to use policy to redistribute wealth across regions.  Instead they redistribute wealth across genders and age groups but those forms of redistribution don’t distort the banking system so much.  The Swedish banking system is also "small as a whole" compared to surrounding markets; you can’t say that about the USA.  Note also that Swedish banks, circa the early 1990s, were simpler creatures than today’s American banking firms.

4. The U.S. doesn’t have any tradition of successful nationalization.  We’ve had plenty of interventions, but for whatever reasons nationalization has not been the preferred model.  I don’t think it is just ideology.  The diffuse and highly federalistic American political system is lacking in accountability and thus it is poorly suited for such policy actions.

5. Nationalization makes it harder to raise private capital next time there is a crisis.  It is a high time preference solution.

6. Presumably the government wants to show it is doing a good managerial job, but in fact the sector needs to shrink.  And would a government-owned bank cut off the flow of credit to, say, Chrysler?