Giving reform a chance

If one is to believe the popular media, economists have finally found one issue to agree on: That Greece can only get out of its atrocious fiscal quagmire through debt restructuring.

Here, I’d like to argue for the opposite, even if that meant that, for once, I’d have to side with the politicians.

Let’s talk contagion first. In case you’ve missed it, repo markets for Spanish, Portuguese and Irish bonds are drying up, which raises flags of alarm for their respective banks and, indeed, any bank that is using them as collateral for funding. Debt restructuring by Greece would create a precedent that would be very hard for the markets to ignore when thinking about the rest of the PIGS.

Instead, avoiding a Greek restructuring (for now) gives a chance to the governments of these countries to take tougher measures to escape Greece’s fate. It also gives a chance to the European Commission and Council to prove that they have learned their lesson and can enforce fiscal discipline on a pre-emptive basis. Basically, it gives a chance to prevent a fresh round of financial instability in the eurozone, and to restore credibility in the institutions backing the entire European project.

The next line of reasoning has to do with “the point” of restructuring: Even with restructuring, the need for a drastic fiscal consolidation in Greece does not go away. Neither does the need for enforcing tax collection, downsizing an over-bloated public sector, eradicating corruption and improving competitiveness.

In addition, any haircut decision—and savings thereof—would have to be weighed against the new debt that would need to be issued to cover the losses of Greek financial institutions; and the much higher interest rates that Greece would be charged for its debt in the future (which would be higher the lower the recovery values and the higher the perceived probability of default).

Add to that the possibility of bank runs, collapse of confidence and the ensuing disruption in people’s daily routines, and you kill all incentives for reform by transforming an economic emergency into a national calamity.

Speaking of reform, it might have been easy to miss, amidst the catchy photos of rowdy anarchists parading in the middle of Athens, but.. there is actually a growing momentum for reform not only among the intellectual elite but also among the broader public—as demonstrated by the numerous self-critical op-eds and the more humble rhetoric of the Prime Minister himself.

On top of that, you have a government in its first year of a 4-year mandate and an utterly discredited opposition that leaves few political options for dissenters but the Communists, the Greens or… the Party of Greek Hunters! The IMF/EU package allows this momentum to continue by providing not only cheap(er) money but also an instrument for discipline and transparency in a country that has had none for years.

So much for the benefits. Now what are the risks of the IMF/EU approach?

Most people see the biggest risk being that Greece fails to deliver. I disagree. The biggest risk would actually be if Portugal or Spain failed to deliver more ambitious fiscal measures in the coming months. The point here being that the massive package for Greece is more about avoiding contagion to the rest of the eurozone than salvaging some 2% of EU GDP.

Then there is Greece itself. Those calling for upfront debt restructuring argue that the current package is fuelling moral hazard with the biggest “bailout” in history; and that, when the “inevitable” happens, the private sector will have to take a bigger haircut, since the official money disbursed would be senior to privately-held debt.

Not entirely. First, all the package does is cover Greece’s financing need for the next three years, including debt amortizations to the private sector—in full! So whatever haircut in the future will have to be considered together with the full repayments that debt holders will receive as a result of the package today.

When it comes to moral hazard, it is ludicrous to think at this point that the rescue package will encourage fiscal misbehavior in the rest of the eurozone or even by future Greek governments, given the painful measures that need to be adopted and the political humiliation of external monitoring.

However.. there is clearly a moral hazard issue when it comes to the holders of Greek debt, many of whom were happy to feed the Greeks with cheap money until they decided otherwise. Here, voluntary initiatives of the type allegedly discussed by German banks are a step in the right direction, even if too timid to counter the moral hazard concern.

But ultimately, the “rescue” of Greece (and of its debt holders) will have to be seen through the prism of avoiding contagion at a time too sensitive for the neighboring economies (and the IMF/EU) to bear.

Mind you, timing is critical: Provided Spain, Portugal and Ireland “behave”, a Greek debt restructuring would be much easier for the eurozone to bear a year or two from today, as the economy would be in better shape and the risk of contagion lower.

Greece may be too small (and too wayward) to bail but it’s become systemic by association. And while the rescue of an idiot who put his house on fire may be against one’s libertarian philosophy, keeping the fire from spreading elsewhere is (as we’ve painfully come to learn) sound policy

Europe’s bazooka is not enough

Back in August 2008, Hank Paulson, then US Treasury Secretary, went to Congress to request the mandate for a potential financial backstop of Fannie Mae and Freddie Mac, in the event of a loss in market confidence.

Faced with the Congress’ inherent aversion to an explicit government guarantee on the two companies, Mr. Paulson’s argument was raw, yet forceful:

"If you have a bazooka in your pocket and people know it, you probably won't have to use it."

We all know how this ended. Less than two months later, the US government was forced to put both companies into “conservatorship”, as markets decided to test Hank’s resolve to put his powerful weapon to use.

Europe’s EUR30bn financial package to Greece is the new bazooka on the block. Even the Greek Prime Minister himself, George Papandreou, seemed keen on recycling the analogy:

“The gun is now loaded” he said to a Greek newspaper, perhaps unaware of the fate of its US precedent.

As it happens, the European backstop alone does not provide a permanent solution. This is because it continues to treat the Greek crisis as a liquidity problem, when many in the markets believe it’s a solvency one. A permanent solution *has* to involve an IMF program, with a clear and feasible framework for swift debt reduction.

So what would be the elements of an effective Fund program?

The program should have two primary objectives: First, to arrest an impending liquidity crisis by restoring market confidence in Greece’s ability to service its debt; and second, to safeguard the long-term viability of the Greek economy within the context of the euro. The latter would have to involve, inter alia, substantial fiscal tightening to foster price reductions and increase competitiveness.

When it comes to the first objective, the Europe’s EUR30bn package is in theory sufficient to address a potential liquidity crisis, given that it exceeds Greece’s obligations in the short-run. However, it is not enough to restore market confidence in the country’s ability to service its debt, now and in the future. This is because, by some calculations, Greece’s debt is currently not on a sustainable path, unless its fiscal effort goes beyond what the Finance Ministry has pledged under the stability and growth program it submitted to the EU.

One reason is that the low interest rates assumed in the fiscal plan may not materialize for some time. Another reason is that, even with low interest rates, the current plan does not envisage a reduction in the debt/GDP from current levels until after 2013: Instead, the debt is forecast to rise until 2011, and then fall slowly from 2012 onward. This may be unacceptable to investors looking for tangible evidence of a prompt fiscal correction

The issue of debt sustainability is also a legal one: Under the Fund’s lending guidelines, large loans (or, in Fund jargon, “exceptional access”) can only be provided if IMF economists can offer explicit assurances to the Fund’s board that a country’s debt level is on a sustainable path.

It is unclear that Fund economists can provide such assurances at this juncture, without either of the following two routes: One involving tougher, frontloaded and visible fiscal measures that go beyond Greece's current commitments, aimed at restoring confidence in the country's ability to control its debt; or another involving upfront debt restructuring.

In my view, the latter is not a viable alternative for Greece. First, although some two thirds of Greece’s debt is held by foreigners, the institutions with the largest exposure (as a percent of total portfolio) are Greek banks. Restructuring would bring about large losses for the banks, potentially causing bank runs, financial instability and a halt of credit. The consequences of growth would be disastrous.

Second, in the context of the monetary union, the only way to restore Greece’s competitiveness is by forcing a reduction in its prices vs. its trading partners (ie a real depreciation). A tighter fiscal policy that includes wage cuts is instrumental for making this happen, and will have to be part of an IMF program—debt restructuring or not.

Importantly, a tougher fiscal adjustment might look daunting on paper but is not impossible: Greece can achieve a great deal with determined steps to fight tax avoidance, the streamlining of an overbloated and inefficient public sector and penalties to those responsible for the massive expenditure “overruns” (a politically correct term for “money in the pockets of favored individuals”). The point of these measures goes beyond fiscal discipline: They are fundamental in fostering a transparent and rules-based environment for doing business.

As Rahm Emanuel said back in February 2009, “you never want s serious crisis to go to waste.” Greece’s crisis should not go to waste; it’s a wake up call that economic growth cannot be grounded on consumption funded by (what was thought to be) free money. The IMF is a necessary partner in this phase of transition.

Ben and his Avatar

I can’t help noting the coincidence of Bernanke’s nomination as both “Man of the Year” and “The Definition of Moral Hazard” in the same week as the release of Avatar... And while Ben has probably settled on which “body” he belongs to, representatives of the voting public have yet to make up their mind.

The recent Senate Banking Committee hearing on his reappointment is evidence of Congress' dilemma: While his re-election as Fed Chairman is coming closer to materializing in recognition of his multibillion dollar rescue(/bailout) of the entire economy, Congress has doubts about the Fed’s future role as financial regulator and supervisor.

In fact, under the current draft financial regulatory reform bill, financial supervision and regulation responsibilities (including those of the Fed) would be consolidated under a single federal bank regulator (other than the Fed).

Given the obvious turf issues, Ben is already fighting back, using every occasion to make the case for maintaining and indeed enhancing the Fed’s supervisory authority. But turf matters aside, the proposed reform may be actually doing the Fed a favor.

The starting point here is that international experience does not offer paradigms of an “optimal” institutional structure for financial supervision and regulation. For example, countries with very different institutional frameworks (e.g. the UK, the eurozone or Japan) have all experienced a major financial crisis recently or in the past.

Then, the case for assigning the roles of both monetary policy and financial supervision/regulation to one and the same institution (the central bank) has to be made at a conceptual level, based on arguments of efficiency and effectiveness:

1) Does the Fed have a comparative advantage in supervising financial institutions?
2) Does the Fed’s role as banking supervisor help inform monetary policy and make the latter more effective?
3) Is the mandate of banking supervision critical for the Fed’s effective execution of its non-monetary policy roles, notably its role as a lender of last resort (LoLR)?

So let’s take these one by one. The weakest argument in support of the Fed as banking supervisor is, in my view, that the Fed has a comparative advantage in fulfilling that role. At the Senate Banking Committee hearing, Bernanke argued that Fed staff have “unparalleled expertise”, being trained economists with a deep grasp of monetary issues. In his view, these skills would become even more valuable as banking supervision expands to include a macro-prudential/systemic perspective.

Sorry Ben, but we don't buy that. To start with, the Fed staff’s “unparalleled expertise” failed abysmally to grasp the scale of banks’ problems at both the micro and macro level, not just before but also well into the crisis. Aside from that, the “right expertise” can always be hired by the institution that needs it. It’s no sexier for a bank supervision expert, or a macroeconomist for that matter, to work for the Fed than for another institution, if the latter is the one with the lead authority in his/her area of expertise.

A stronger argument is that the Fed’s role as banking supervisor can help inform its monetary policy decisions and make the latter more effective. Existing academic literature is inconclusive on this topic, though I personally think that current research efforts (exploring the links between monetary policy and the behavior of financial institutions) will provide more solid support. Nonetheless, the argument is made controversial by the Fed’s own practice and by Bernanke’s view that the best tool to address “excessive” risk taking in the financial sector is not monetary policy.

Re. the former, Ben admitted at the hearing that “in normal times”, FOMC meetings (on monetary policy) spend very little time, if any, on the state of the financial sector. Of course we all know now (with the benefit of hindsight) that what the FOMC viewed as “normal times” were not normal at all.

Aside from that, this de facto separation of monetary policy decisions from financial stability issues is revealing of the Chairman’s intellectual belief (which he has stated time and again) that financial sector “excesses” should be addressed by appropriate regulation instead of interest rate policy. If Ben insists on that view, the case for uniting the authority for monetary policy and banking supervision/regulation under the Fed is pretty tenuous, at least on the grounds of making monetary policy more effective.

Bernanke’s strongest case in support of the Fed’s role as supervisor is based on the critical role it can play (not in preventing but) in managing financial crises—i.e. once they happen! The argument has a number of dimensions including, inter alia:

First, when a financial institution is under distress, the Fed can benefit immensely by its own in-house supervisors, who can assess the state of the institution, evaluate its collateral against which it might lend to it (under its LoLR function) and, thus, protect the taxpayer.

Second, the Fed’s role as banking supervisor, in conjunction with its mandate as overseer of the payments system, is critical for allowing it to understand the systemic implications of the distress in an individual institution, and therefore assess the tradeoffs between providing support to a failing institution or letting it fail.

These arguments have merit but do not necessarily make the Fed’s supervisory role absolutely essential. For example, provided that there are officially-established communication links between the Fed and the supervisory agency, the Fed would have access to all the information it needs to assess the situation. Indeed, the distressed institution itself would cooperate in the provision of information, as it happened when Bear Stearns went under.

But what is more important here is to weigh the benefits of the Fed having its own people managing the nitty-gritty details of a bailout with the political costs (to the Fed) associated with that role. The backlash from (what was inevitably seen as) the Fed’s gross failure to protect the taxpayer in the AIG bailout (legal excuses notwithstanding) highlights the political risks of too direct an involvement by the Fed with decisions that ultimately belong to the fiscal authority.

In my view, this political risk is a cost sufficiently large to tilt the balance against granting the Fed the lead role as financial supervisor, notwithstanding the benefits mentioned above. Mistakes, or actions perceived as inequitable and unfair, will always be made, especially in a crisis situation, so an arm’s length involvement by the Fed can actually help safeguard its monetary policy independence—an independence that should remain sacrosanct.

As a result of the bailout mess, the Fed has now found itself engaged in a PR exercise to defend not only the details of its bailout actions but also the rationale and soundness of its monetary policy decisions. It’s still unclear whether it’s winning. But, maybe a cleaner way to go is to avoid altogether the public’s confusion between “Ben: Man of the year” and his “Moral Hazard” avatar.

Greece should seek a precautionary standby… now!

Eurozone bond markets have for years now been operating under the assumption of a new “impossible trinity” (1/): That you can’t have a single currency, a (virtually) independent fiscal policy and a no-bailout clause all at the same time.

This assumption has continued to prevail even after the recent budgetary shenanigans in Greece (and fiscal slippages also elsewhere in the eurozone), judging from the latest pricing of Greek sovereign CDS.

While much wider than in early October, when the new government took office, Greek 5yr CDS spreads, at 200bps on Friday, still price in just a 6-8% probability of a credit event. (By comparison, Dubai Holding’s spread closed at 1870bps and Ukraine’s at 1350bps).

Markets are probably right… Most likely, Greece will deliver a series of fiscal consolidation promises to the Euro group (of eurozone finance ministers), will become subject to enhanced surveillance by the European Council under the Maastricht Treaty’s “excessive deficit procedure” (EDP) and, as such, obtain an implicit financial backstop from its eurozone fellows…

But here are the problems with this approach:

First, Greece (and some other vulnerable eurozone members) would be better off with an explicit financial backstop, not an implicit one. The EU’s backstop will always have to be implicit to avoid moral hazard and complacency by the Greeks, the Irish, etc. However, an explicit backstop would be much more effective in stabilizing the Greek bond markets and in curbing uncertainty about potential financing troubles.

Second, any EU backstop would likely come after a crisis hit, instead of being pre-emptive. That’s lousy policy, not least because, were a crisis to hit, it would raise uncertainty and possibly spread to other markets, even if the EU were quick to step in. It's also lousy because there is absolutely no excuse for not having a crisis-prevention framework into place (over and above Greece’s own policy promises, for what they’re worth): Greece’s fiscal quagmire has been known for a long while, so policymakers would not exactly be caught by surprise!

Third, the European Commission/Council have a truly hopeless track record of enforcing fiscal consolidation or structural reforms on eurozone members. This means that whatever plan is laid out for Greece, it could lack the credibility to pass the “rating agencies’ test”, let alone the “markets’ test.” Ongoing uncertainty and lack of credibility would only breed volatility, which is neither good for Greece nor for investors still recovering from the Great Panic of 2008. In addition, to the extent that the Europeans prove, once again, incapable of enforcing fiscal and structural reforms, implementation slippages by Greece would set a dangerous precedent for other eurozone members to follow.

Fourth, direct involvement by eurozone governments in Greece’s fiscal plan (and, if need be, bailout) raises issues of conflicts of interest. It could turn out, a couple of years later, that Greece cannot put its finances in order.

This is not just a thought experiment by the way: Greece’s fiscal problems are deep-rooted and structural—a symptom of endemic problems, including an over-bloated and unproductive public sector, a pervasive culture of tax evasion, and widespread corruption at every imaginable level, from politics to the judiciary to the hospitals! This has hurt not only the government’s ability to put its finances in order; it has also hurt Greece’s competitiveness as a place to do business, undermining future growth (and, in turn, the fiscal dynamics).

If fiscal consolidation measures and structural reforms fail to deliver the necessary correction, the next route to follow may have to be debt restructuring. And here, the Europeans have too much at stake: Almost 70% of Greece’s near-EUR300 billion debt is held by foreigners, with a big chunk of it by French, German, Italian and other eurozone institutions (per the BIS). It is easy to see why the Europeans would not be “neutral” negotiators, and likely force too big a burden of adjustment on the Greek side.

This may sound “fair” on the surface, yet consider that these guys have completely failed to impose even a modicum of market discipline in recent years, being lured by the appeal of Greek debt as a euro-denominated product with an easy spread!

So here is a better and cleaner way to go: Greece should seek a “precautionary standby arrangement” (SBA) from the International Monetary Fund (IMF).

Under the SBA, Greece would commit to a combination of deficit-reducing and structural policy measures over 2-3 years (frontloading the former to sharpen the “teeth” and credibility of the SBA). The arrangement would be precautionary, with no IMF resources drawn in the baseline scenario where Greece faces no financing gap. However, Greece would have immediate access to Fund resources in an adverse scenario of financing troubles due to either a Greek-related or an “exogenous” market turmoil.

The advantages of this route compared to an EU solution are enormous in my view:

1. Greece would enjoy an explicit financial backstop rather than an implicit one.

2. The backstop would help prevent any crisis from happening, instead of cleaning up the mess ex post facto.

3. Provided the SBA has “teeth”, the seal of the IMF would be a great palliative for the markets, helping impart credibility to a government that has none.

4. By laying out specific benchmarks/conditionalities, compliance with these would be easy to monitor by the markets and by the Greek public, reinforcing government accountability.

5. The Maastricht Treaty’s “no-bailout” clause would remain intact, while the ECB would be able to maintain its autonomy over monetary policy and liquidity provision decisions, which would fortify the credibility of the euro.

6. The arm’s length (or, at least, indirect) involvement of Eurozone governments to the process would avoid the conflicts of interest I mentioned above.

7. Finally, Greece could set an example for other eurozone members to follow, helping maintain stability across the eurozone.

It is easy to see why some European policymakers might balk at this idea, out of concern it would amount to an acknowledgement of failure to deal with bread-and-butter problems in their own back yard. As a matter of fact, it is! The Stability and Growth Pact needs major rethinking (more on this in a subsequent piece).

But while Europe’s economic integration goes through yet another phase of soul searching, let the necessary measures of fiscal and economic stabilization proceed in a clean and orderly way.



1/ The original “impossible trinity” in international economics is the argument that you can’t have a fixed exchange rate, an autonomous monetary policy and free international capital flows all at the same time.

Bankers' Pay Revisited

Yet again the debate on bankers’ bonuses has taken an ugly turn, with ostensibly sober commentators getting caught into the populist flow…

…Which is really too bad, as op-eds like this are a missed opportunity to inform the public about the fundamental problems in the financial sector (of which compensation is a by-product) and build support for policies to address them.

It’s in this latter spirit that I’ll raise here three key questions on bankers’ pay and hopefully offer some food for (constructive) thought/policy:

1. Are bankers paid too much, at the expense of their firms' shareholders? In other words, do bankers grab a bigger share of their firms’ profit pool than they are warranted by the objective of maximizing shareholder value?

2. Since taxpayers are called, now and then, to foot the bill of keeping one or more banks alive, should executive pay be so regulated as to control risk-taking by individual employees?

3. Are bankers paid too much…. full stop?

I’ll start with (2), which is the easiest to answer in my view: So.. I don’t think so. Or, at least, not beyond what the Fed’s recent proposal tries to achieve, which is to get bonuses to reflect the risks of employee activities, and to use longer periods for measuring performance for bonus purposes. But beyond this, preventing the next financial failure rests predominantly on improvements in firm-wide (and industry-wide) monitoring and management of risks.

The challenges here are vast: From developing better tools to measure risks more accurately; to appropriately monitoring risks across different business units (e.g. to avoid “balance sheet arbitrage”-type activities like those of AIG); to designing appropriate counter-cyclical capital requirement ratios... There is also a case (which I discussed here) for making financial institutions pay an insurance fee against future failures in the sector (à la FDIC deposit insurance fee).

Provided we can address these challenges, regulating executive pay is almost redundant as a tool to protect the taxpayer.

Then comes the question of whether bankers are paid too much at the expense of shareholder returns—by which I mean both absolute and risk-adjusted returns. One way to go about answering this question is to look at the volatility-adjusted excess returns (the Sharpe ratio) of financial firms vs. the market's.

My focus here is on "the stress-tests 19 ex-GMAC" rather than the entire financial sector, which includes small regional banks with no "bailout" and no “bonus issue”. I look at the period from November 1999 onwards, when the Glass-Steagall Act was repealed, though the results broadly hold for longer periods.

Turns out the majority of these institutions have outperformed the S&P 500, both in absolute and volatility-adjusted terms. Indeed some have done exceedingly well, with Sharpe ratios of four (JP Morgan, BofA) to 15 (Goldmans) times higher than that of the S&P500.

One eyecatching underperformer is Citi, which, provocatively, went on giving out fat bonuses as late as end-2007. The likes of SunTrust, Regions and KeyCorp have also trailed the S&P500. As simplistic this exercise is, it does suggest that, in many cases, the size of bankers’ salary pools has not at all compromised financial firms’ ability to reward their shareholders competitively.

One caveat of course is that realized volatility is only a partial measure of ex ante risk: Arguably, the government’s financial rescue helped avert a much more disastrous outcome than shareholders experienced. In other words, the “true” risk adjusted return was much lower ex ante, esp. if one were to include tail risks.

I buy that.. Still, a financial sector collapse would have probably meant a disaster for the entire economy and every firm in it, from retailers to car-makers to pharmaceuticals, due to the ensuing credit crunch. So it's uncertain how such an outcome would have affected relative performance.

Importantly, the implications for the level of executive pay are unclear: It’s not the level per se that is important for managing risk, but the structure of pay incentives. Even more critical is the ability of financial firms (and their regulators) to monitor risk at the firm/industry-wide level, as I argued earlier.

So then we come to the question of whether bankers are paid “too much…full stop.” The knee-jerk response of many an inhabitant of Main Street (“YES!”) is driven by the large wage differentials between finance professionals and employees in many other industries. These differentials are an empirical fact, even for workers with similar skills and even after correcting for “compensating factors” (e.g. unfavorable working conditions).

Literature offers a number of explanations: Different incentive conditions between sectors leading to different levels of efficiency wages; “unobserved abilities” by employees in highly-paid sectors; weak coordination of wage bargaining across sectors, leading to disparities in the share of industry rents going to employees; and variation in the profits of different sectors (allowing profitable industries to pay their workers more).

Here I’ll focus on the latter, because it is the most relevant for our “too much” discussion: If it is indeed large rents in the finance industry that drives bankers’ pay, could it be that financial institutions make too much profit?” Or, if you like, “Is there too little competition in the financial sector?”

Here is where things get tricky: Assessing the competitive environment in the financial sector is extremely difficult (see a nice discussion on this by Stijn Claessens here). Importantly, unlike many other industries, the “optimal” level of competition depends on balancing what are often competing objectives: The desire to improve access to financial services for a wide range of firms and households at low cost; foster product innovation; and ensure financial stability. The increasingly complex and evolving structure of financial institutions and the presence of scale economies and network issues complicate the task further.

This does not mean that policymakers should give up trying… on the contrary. In my view, a comprehensive assessment of the benefits and costs of the sector’s existing market structure, and the identification of measures to improve it (with both the stability and the access/efficiency objectives in mind) should be a top policy priority. Instead, what we’re getting these days are rash proposals to potentially limit banks’ size based on too-big-to-fail considerations, which completely miss the broader point of what is an “optimal” market structure.

Bottom line… Whatever the problems with bankers’ pay, they are the by-product of more fundamental problems in the financial sector as a whole: Inadequate risk-management and monitoring systems, unskilled (or complacent) and fragmented regulators and, possibly, a sub-optimal market structure.

So rather than going for the easy targets to appease a blood-thirsty audience, governments and journalists alike had better re-focus their efforts on policies that truly matter.

The Good, and the Quick ‘n Dirty

You look at the key housing indicators and you’re probably thinking the government’s homeowner support plan has got to be working… mortgage rates at record lows, house prices stabilizing, inventories coming down, new home sales (begrudgingly) crawling upward.

Yet, it all depends on how you define “success”… there is "temporary feel good" success… "clean up now, pay later" success… "everything/everyone but the kitchen sink" success… and success as in "targeted help to the neediest" and "permanent solutions to the root problems."

I fear that only a teeny portion of taxpayer money has gone towards this latter type of success. To see why, one has to judge whether the government’s measures are geared towards tackling the root problems in the housing sector; whether they are cheaper compared to alternatives; and whether they target the neediest.

By "root problems" I mean the excessive supply of homes for sale, demonstrated by the record housing inventories back in 2007/08; and the excessive mortgage debt taken on by people who could not afford it.

By “neediest” I mean households at high risk of foreclosure with too few resources to either relocate or trade down. In turn, by “high risk” I mean households with negative equity and a meaningful cashflow problem (e.g. due to the loss of employment or the sudden increase in their monthly mortgage payments).

The "and" is critical for identifying the neediest: According to research by the Boston Fed (here and here), negative equity alone is not sufficient to prompt walk-outs, as many have argued/feared (unless it’s at egregious levels and the homeowner does not expect to return to positive equity within a reasonable horizon). A cashflow problem is also necessary.

So now let’s take a look at the government measures:

First, you have the Fed’s purchases of mortgage backed securities (MBS) (Cost: To be determined). The purchases have boosted MBS prices, allowing MBS investors to make nice profits. Higher MBS prices have also meant record-low mortgage rates, encouraging purchases of new homes or the refinancing of existing mortgages.

The scorecard? Mixed at best. For starts, the program fails to target the neediest. Those refinancing or purchasing new homes are people who can afford to do so. OK, you might say, but doesn’t this help clean up the large housing inventories? Perhaps… but inventories can also be reduced by letting house prices fall sufficiently, instead of propping them up with artificially low mortgage rates.

Indeed, I’d say that letting prices fall would be preferable, given the fiscal cost of the likely losses on the Fed’s MBS portfolio; the complications for the conduct of monetary policy; and the empirical evidence that lower house prices alone do not prompt walk-outs by the buckets, unless there is a also cashflow problem.

OK OK, but surely the profits to MBS investors can’t have hurt, given the dire state of the financial industry last year? Yeap, profits are nice, but… MBS (and other asset) prices would equally respond to measures tackling the root problem: Excessive leverage in the household and financial sectors. Financial-sector leverage was partly addressed by the capital increases dictated by the stress tests. In contrast, VERY little has been done to reduce household leverage.

Moving on to the measures by the Treasury:

First-time home buyer credit (Cost: $14 billion so far, per the CBO): Originally the scheme offered tax credits to new home buyers, but was recently expanded to also cover long-time homeowners and/or homebuyers with higher incomes! The scorecard? Thumbs down! Yet again, the measure does not target the neediest, fails to address the leverage problem and artificially props up house prices.

Support to Fannie and Freddie (Cost: $96bn of cash infusions and $43bn of subsidies in 2009 alone, per the CBO): The idea here is that Fannie and Freddie buy more mortgages from banks (thus allowing banks to extend more mortgages); and facilitate securitization and onward MBS sales to investors by providing guarantees that insulate MBS buyers from the risk of default.

The scorecard? Thumbs down… big time! The measure fails to benefit the neediest, fails to reduce household leverage and, on top of that, is aggravating the fiscal hemorrhage, since we have yet to see *a* plan for the institutional resolution of Fannie and Freddie.

The only program providing targeted help is the Home Affordable Modification Program (or HAMP). HAMP has allocated up to $75 billion to finance the modification of primary-residence mortgages owed by people in financial hardship. But progress has been painfully slow—the CBO estimates that only a tiny portion of HAMP resources have been spent this year. (The Treasury's latest progress report on HAMP shows 651,000 active trial and permanent modifications as of end-October 2009).

Part of the problem is that HAMP rests on the collaboration of mortgage servicers, which slows down the process, on top of limiting the amount of relief provided by the modification (e.g. due to “net present value rules” in the servicing agreement). The latter is crucial since, the lower the relief, the more likely a household will eventually fall back into arrears.

What I would have liked to see instead is true relief to low-income households with little home equity and a serious cashflow problem. If the hardship is due to employment loss, monthly grants would be offered to reduce a homeowner’s mortgage burden until s/he finds another job. If the cashflow problem is due to a jump in the monthly payment (e.g. due to an unaffordable ARM mortgage obtained through predatory lending), the relief should be permanent. But to avoid the risk of the homeowner pocketing the taxpayer money and then selling the home at a profit, help should take the form of monthly grants instead of one-off debt relief.

By my count, this relief would be targeted, tackle the leverage problem and would likely be swifter by avoiding the intermediation of mortgage servicers. It would be fiscally responsible by foregoing blank taxpayer checks to people with comfortable incomes. It’s also pretty obvious… which makes it all the more astounding why the government has chosen to bypass a good solution, opting instead for the quick ‘n dirty!

The plain vanilla option for bank reform

I’m taking a quick break from my blog break to throw in some food for thought re. the bank-reform debate, which has been simmering in earnest.

I also feel pretty energized after a mind-blowing trip to Asia, which has forced me to rethink the definition of “construction boom”, “shopping mall” and... “exotic cuisine”!

Anyway, at the crux of the reform debate are measures to prevent banks from engaging in the risk-taking behavior that led to, yeap, “the worst financial crisis since the Great Depression.” Proposals have targeted, inter alia, bankers’ pay, with the view of curtailing greed and short-termism; and bank capital requirements, to basically make banks’ risky activities more expensive and less procyclical.

Personally, I’m against the former, and not because I have any particular affinity for bankers (unless they are economists!). I just happen to think that, per Econ 101, employee compensation, together with the return to shareholders, should be both derived from a firm’s profit-maximization exercise—provided this exercise also internalizes the systemic implications of the bank’s own risk-taking behavior.

Put differently, if we can make financial institutions pay explicitly for what is now an implicit, unpaid-for insurance provided by the taxpayer against a systemic banking crisis, I see no reason why banks cannot distribute any left-over profits to their workers and capital owners as they please.

For this same reason, while I partly see the logic of the second proposal—to introduce counter-cyclical capital requirements—, I don’t think it’s enough to do “the job”: Yes, it might well discourage banks from engaging in “excessive” risk-taking behavior in good times; but it still does not make banks pay in advance for the next financial bailout which, believe me, will happen again at some point.

Against this backdrop, one idea for making banks pay for systemic-risk insurance was put forward in a paper presented at the 2009 Jackson Hole symposium by MIT economists Ricardo Caballero and Pablo Kurlat.

Accordingly, banks would pay a fee to the Fed in exchange for potential access to insurance, which would be triggered if systemic risk exceeded a certain threshold. This access to insurance would take the form of "TICs" (or Tradable Insurance Credits)—securities that would be issued by the Fed to the fee-paying bank, providing access to Fed guarantees on a pre-specified pool of the bank’s assets.

The paper has some interesting insights and, actually, a somewhat different tilt than the issue I’m raising in this piece (Their point is, in part, that there is a need for a new policy tool to help remove market uncertainty about the depth of bank losses during a systemic financial crisis). So I recommend that you read the whole thing.

Insights aside, I think this type of proposal suffers from a number of flaws, some of which are fundamental. On top of that, it is far more complicated than what I think is a more straightforward solution, which could not only help generate a less procyclical risk-taking behavior, but also address the need to make the now implicit insurance explicit. Let me explain:

Flaw number one in the Caballero-Kurlat approach is the fact that the guarantees would cover a financial institution’s assets (instead of its liabilities).

Why is that a problem? It is, because it would make extremely difficult the failure of any too-big-to-fail financial institution, even if such an institution “deserved” to fail. This would unduly protect the owners of such an institution, despite what might have been excessive risk-taking, lack of oversight and/or sheer incompetence on their side.

As an example, rewind to March 2008, when a (clearly systemic) financial institution in the name of Bear Stearns is at the brink of going bust. Now, an eventuality of that nature is bound to trigger a TIC-like guarantee by the Fed to every financial institution holding TICs, including Bear Stearns.

This is despite the fact that Bear Stearns may be actually insolvent and thus “deserving” to fail (yes, we can debate this, but in a separate forum). The distinction between a liquidity and a solvency crisis is practically irrelevant in the TIC framework.

So this is how it would go… Bear Stearns is about to fail, systemic risk rises unexpectedly, Fed guarantees are triggered, Bear Stearns is saved, systemic risk subsides and all ends well… only that the principle of efficient resource allocation has been wildly damaged: The most short-sighted, over-levered and incompetent bankers on Wall Street are still allowed to roam around, feeling good and getting ready to go back into the game.

To be sure, the Fed (or the relevant supervising institution) might still decide to declare Bear Stearns bankrupt and wind it up, while providing guarantees to the remaining financial institutions. But that would trigger follow-up complications:

E.g. how would we (and the Fed) know ex ante that, urrrh, Lehmans or AIG, say, are soundly-managed institutions deserving to survive, courtesy of the Fed’s guarantees? Or, if the Fed were to trigger its guarantees on a selective basis, what would that do to market uncertainty—the very problem the TIC proposal was meant to address?

But let me go to the second fundamental flaw of the Caballero/Kurlat proposal: Which is that it confuses the roles of the fiscal and monetary authorities in a crisis resolution framework. Contrary to what they suggest, the provision (and, ultimately, the cost) of any guarantees on any financial institution should be the role of the fiscal authority (ie the Treasury), NOT the Fed.

True, the Fed did provide backstops against certain assets or liabilities of financial (and non-financial) institutions during the 2008 crisis, as the crisis escalated. But that was due to (a) the absence of a systematic framework for crisis resolution; and (b) the inability of Treasury and Congress to respond proactively to the dramatic events that unfolded. Yet, what we need is not the Fed taking the lead in what is essentially a fiscal activity; but a solution that would help avoid the need for the Fed to get financially involved, for the sake of its financial and political independence.

So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.

If you think this provides too nice a treatment to the creditors covered, think again: These guys would now be getting paid much less for their lending to the bank, since the default risk would now be minimal thanks to the explicit insurance the bank is paying to the government.

Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

What are the advantages of this approach?

* First, it allows for the failure of insolvent, poorly-managed institutions, inlcuding systemically important ones.
* Second, it makes financial institutions explicitly pay for the insurance that taxpayers have been implicitly providing to them.
* Third, it can be designed to be countercyclical and incentive-compatible.
* Fourth, it provides provides a more predictable framework for crisis resolution than the status quo, notably with regard to the treatment of the different parts of the capital structure, if it were to fail. Uncertainty about the treatment of shareholders and creditors of different seniorities was a major driver of the market volatility that prevailed in 2008 and early 2009.
* Finally, it makes it clear that any net costs from the resolution of a failed financial institution will be borne by the fiscal authority instead of the Fed.

So here you go, my first wonkish piece for the first official day of Fall. Pretty plain vanilla, dare I say, compared to some of the alternatives out there. And, believe me, after weeks of heated policy debates over silk-worm skewers, bamboo fungus appetizers and live squid entrees, plain vanilla sounds good to me!

Going around in circles on the toxic assets

Who would have thought there might come a day when we’d be asked to compete for our share in a pile of junk?!

Harvard’s Lucian Bebchuk suggests precisely that. His proposal for “jumpstarting the market for troubled assets” has been featured in various media sources, including the FT (here), Bebchuk himself (here) and, recently, by Mark Thoma (here).

Bebchuk’s basic idea is this: In order to encourage price discovery for the toxic assets lying in banks’ balance sheets, the government should allow multiple private funds to compete for them. In addition, to drive down its own participation, the government should make the private funds compete for the public funding made available for purchases of toxic assets under the Public Private Investment Fund plan (PPIF).

Interesting idea but, alas, I don’t think it does the job! I'm about to give a fairly lengthy argument why it doesn't, and what should be done. So if the term “discount rate” makes you yawn, I recommend scrolling down to the conclusion. Here we go:

The assumption driving PPIF is that the current “market” prices for toxic assets considerably understate their “fair” price due to the illiquidity of markets, a high cost of funding of potential buyers, etc. If only banks could sell their toxic stuff at prices closer to “fair”! Their health would by and large be restored and the government would need to pay far less for bank recapitalizations!

The PPIF, in theory, solves these problems (a) by providing partial government funding, thus lowering potential buyers’ cost of capital; and (b) by encouraging a simultaneous buying action on a massive scale, to address the current problem of (a lack of) collective action, whereby early, lone movers get burned.

In practice, however, nothing is solved unless market participants have a sense of what is “fair.” How can we find out? Bebchuk says by having multiple private funds compete for the toxics. Let’s see how/if that would work:

The problems with the theory: Think of a toxic asset—a mortgage backed security (MBS), say, backed by subprimes. And say I am an investor lured by the idea of teaming up with Geithner to buy a few millions worth of MBS junk of the above variety.

Now, suppose I expect subprime borrowers to default with probability p over the life of the mortgages. Very simplistically, this means that, if I held the MBS to maturity, I’d get its face value with probability (1-p) and a recovery value (given default) with probability p. The “fair” price of the MBS will then be the weighted sum of these two values discounted back to present.

So now with my estimate of a “fair” price I go out and make a bid. In principle, I would like to bid below this “fair” price, so that I can pocket the upside. But what Bebchuk’s competitive process does, in theory, is to drive participants’ bids up to “fair.” The idea being to incur the minimum losses possible for the seller banks.

Sounds great, no? Problem is… “fair” depends on my discount rate (my cost of funding these securities). In turn, this depends on how much Geithner is prepared to put in. So I go and knock on Treasury’s door. Geithner opens and (per Bebchuk) confesses that, “as much as I like you, Chevelle, my heart lies with the American taxpayer, so we’ll make you compete for our cheap cash. Show us your money!”

I’m now in a dilemma. I can’t bid too low, because I’ll be thrown out of the game. But then, how high? The only variable I have to guide me is the MBS’ current “market” price. This determines the maximum amount of capital I can put in without going underwater. In fact, that’s exactly what I do: I bid near that upper boundary, to ensure I win the game.

But that’s no help for Geithner: At that level of my own participation, I’ll bid for the “market” price, banks will incur large losses (or they won’t sell!) and more taxpayer money will be needed for recapitalization.

In other words, Bebchuk's idea of competing for public cash simply shifts the form of the government's participation: It reduces the subsidy to private investors; but it increases the amount needed to recapitalize banks.

More problems in practice: In practice, there are other complications. First, it’s questionable whether we can find enough private players with the size and expertise to generate the level of competition that Bebchuk envisages.

Toxic assets are very diverse and, with a few exceptions, participating private funds will likely have only niche areas of expertise. The resulting “market” will be very segmented, with the concomitant implications for competition and liquidity.

Secondly, different private funds have different costs of capital. This means that competition for the government’s cash will provide a clear advantage to the big guys with lower cost of capital—the Blackrocks and PIMCOs of this world. This raises issues of fairness.

Conclusion (The scrollers can start here): Ultimately, the government is in this either way. So rather than going around in circles, Geithner should just try to solve the problem with an end-game in mind. It’d go something like this:

My To-Do List, by T.G.

1. Calculate the hole in the banking system on a mark-to-market basis
2. Assess the probability that its size will prompt a popular revolt
3. If higher than 70%, prepare for the orderly liquidation of selected financial institutions. Emphasis on “prepare”, “orderly” and “not screwing up” (again).
Note to self: In the (unlikely, of course) scenario where “orderly” demands the exercise of the N(uclear) option, convene urgently a panel of linguists to find a politically-acceptable term for the policy move.

4. Re-calculate the hole in the banking system that remains.
5. Now choose between:
(a) Bailing out the banks via recapitalization
(b) Subsidizing private funds sufficiently to get them to bid the “fair” prices you need to cover the banks’ hole.

The pros of (a): Faster and “cleaner”, probably.

The cons of (a): Americans' loathing for higher government ownership of banks. Americans bigger loathing for a fresh fat bailout for the bankers. An 83% probability that I receive their collective wrath, eggs and tomatoes within 12 months.

Pros of (b): The word “private” features prominently in the PPIF acronym.

Problems with (b): The fairness and fragmentation issues above; implementation delays, due to complexities in designing the terms and conditions for participation etc. (a la (TALF)
(Second note to self: If we went for (b), avoid at all costs giving the impression that the government will be effectively setting the prices for the toxic assets.)

6. Oh, and before I forget… file my tax returns by April 15th!

Digesting the N-word

Americans’ aversion to bank nationalization makes me think of my culinary distaste for jellyfish. In fact, it’s worse… I actually have no ideological objections to jellyfish quivering on a plate; it’s just when faced with the choice, I’d rather go for plain old chicken rice!

But here is my advice: Get over it!

First, because state-owned banks do not have to be as “repulsive” as you think. True, some strands of academic literature (including this one by La Porta & friends) have found that government ownership can negatively affect financial development: Growth in private-sector credit turns out to be lower; access to credit by small or medium enterprises lower; operating efficiency of state-owned banks lower; and overall financial stability also lower.

But these results are biased by the fact that state-owned banks tend to be found in countries where the government’s overall intervention in the economy is high, laws are inadequately enforced, institutions are weak and corruption prevalent. Indeed, when one controls for the weakness of the overall institutional environment, the negative impact of state ownership is much lower (per La Porta) or statistically insignificant (per other studies).

Similarly, researchers from the Inter-American Development Bank (IADB) found (here) that, while the profitability of state-owned banks tends to be lower than private banks in a global sample, this is not true when one focuses only on state-owned banks in industrialized economies. This suggests that given an appropriate institutional, regulatory and competitive structure, bank ownership per se is less relevant.

Finally, another paper by IADB economists finds that state-owned banks can (and do) take advantage of their more stable funding conditions and deposit base during downturns to increase lending to the private sector—that is, they can help reinforce the countercyclical objectives of monetary and fiscal policy (there are caveats with this finding, but I’ll leave those for another wonky blog).

“So ok,” you say, “I could digest state-ownership in theory. But this doesn’t mean I should actually order it! After all theory suggests that, at best, public banks are no worse than private banks, not that they are better!”

Fair point. But, in case you haven’t noticed, our private banks are already in zombie mode, burdened with toxic assets and unwilling to lend despite being flooded with Fed cash. The government’s financial commitments to the sector are already huge and getting bigger. And the government is already interfering with banks’ operations, be it mortgage modifications, commitments to lend or restrictions on executive pay.

This is the worst of every world: The equivalent of a nasty chicken & jellyfish mash! Why?

First, despite the enormous financial burdens on the taxpayer, the measures taken so far (recapitalization and bank debt guarantees) have not succeeded in restoring confidence in the sector, to bring down liquidity premia and reduce the private sector’s cost of capital.

And if you think that Geithner’s “plan” to team up with private investors to buy toxic assets is a better alternative to full government involvement, I’d argue that so long as the private sector’s cost of capital remains high, private investors will not go in, barring a very large participation by the government and/or the purchase of these assets at heavily marked down prices (with the obvious implications for bank recapitalization by, urrr, the government!). But I’ll discuss the (f)utility of Gethner’s plan in another blog.

Secondly, among the things that distinguish a “good” public bank from a “bad” one is governance: The public bank should have operational independence. Once the government sets a well-defined set of objectives for the public banks, it should be up to the banks’ management to decide how to achieve those objectives. This is to ensure that public banks are not plagued by the kind of political interference that has been detrimental in some developing economies.

Yet, what we are getting today is a government intervention that is the opposite of transparent, predictable and arms-length! The mandate of intervened banks remains undefined, the rules of the game have been changing half-way through and the government is increasingly interfering with banks’ operations.

And if Geithner’s stress tests were purported to be the uniform test for government intervention, for the moment they lack the transparency to be that—it’s even unclear what criteria will be used to assess bank solvency.

Finally, critical for a successful government intervention are measures to ensure a level-playing field for those banks that are NOT intervened. In Norway for example, nationalized banks were given restrictions on the expansion of their assets to ensure that they would not use their competitive advantage (cheaper funding costs) to displace private banks. But here, discussions in this area do not seem to have even begun. So we have a playing field full of potholes and with the players running blindfolded.

To tell you the truth, my own chicken-rice scenario would be to have the toxic assets removed from banks’ balance sheets by means of a government-owned (but independently managed) TALF-like vehicle; the assets purchased at heavily marked down prices (i.e. any upside goes to the taxpayers); and the resulting capital holes in the banks refilled (by the government and, ideally, some private sector participation), after wiping out existing shareholders and replacing their managements. The cleaned-up banks could then continue to operate as private concerns.

The problem with this, however, is that the resulting recapitalization costs may turn out to be prohibitive, if we are to use current “market” prices for the write-downs. In that case, nationalization would make more sense, since the government’s cost of capital is much lower (i.e. the present value of these assets higher) and since it can afford to hold the assets to maturity without the fear of a run.

As I mentioned, there are still many issues to address in a sequel to this post, e.g. which banks should be nationalized, how to do this without undermining the others, to how to go on about removing the toxic assets from the banks that are not intervened, etc.

But for now, I’ll just close with a confession: I have yet to try jellyfish myself, but it may well happen the day Citi becomes public. I hear it stings!

Playing the bankers’ advocate…

Bankers are so vilified these days that “Banker” is at the brink of replacing “Economist” as a synonym for “Dismal”! Not that I’m jealous… I’d be more than happy to see economists passing on the baton of dismalness. But I’d rather see it go to a more deserving group!

On a more serious note, I feel the debate on executive pay is getting a bit out of hand, particularly when I see respected academics and commentators adopting the Michael Moore approach to op-ed writing. Certainly, news of bankers eating up taxpayer money while splurging on luxury jets hasn’t helped.

But adding fuel to the fire with populist indictments is not that constructive, if one wants to offer lessons for policy. So let’s take a look at a few of those:

1. “Brain” drain? Who cares? The argument goes that bankers contribute far less to this world than, say, surgeons... ergo pay restrictions would help shift “the best and brightest” towards more useful industries.

Well, I beg to disagree. The surgeon who will save me from dying is undoubtedly valuable. But, provided the industry functions properly, so is the banker who will help me secure a decent retirement once I survive the surgery; and so is that other banker who will choose to invest in the development of the cutting edge surgical equipment that my surgeon will use. And yes, I’d like to see (some of) the best and brightest making these decisions.

2. Bankers are overpaid: Before getting into the “over” prefix, let’s first explain "paid." Bankers’ pay is the cost that banks incur to employ one of the factors of production (labor)—the other being capital. Now, bankers could be overpaid under three scenarios:

(a) Aspiring bankers seeking a job have bargaining power over their employers, e.g. because only the "select few" can enter the job market. But this is not true. Anyone with access to higher education and a (pretty basic) grasp of quantitative methods can try “the banker’s path to success and personal fulfillment”, if they so choose. The sheer diversity of bankers’ backgrounds is the blatant proof, with the Harvard MBA sharing the same roof as the son of a Texan policeman and a math graduate from Bangalore.

(b) There are economic rents in the banking industry, which banks distribute in large part to their workers (e.g. in order to attract talent and foster productivity and loyalty). This argument may not be entirely off the mark. I welcome inputs by industrial economists here, but my understanding is that the US banking system is monopolistically competitive (e.g. see here). Which of course allows for rents.

But then the issue at stake has little to do with executive pay and far more with identifying an optimal structure for the industry—one that encourages competition and innovation without compromising prudential objectives.

Once that structure has been identified, executive pay should be left to settle on its own, as the by-product of this structure. The distribution of any resulting “rents” to bankers would only be harmful if (a) it were geared towards rewarding short-term performance (which has been part of the problem recently); or (b) if it amounted to “robbing” the owners of capital from their own share of the pie. Which brings us to our next point….

3. Did bankers "rob" the banks’ shareholders? Not exactly. Taking as a proxy for the sector's return on capital the total return on the stocks of financials, returns have tracked quite closely, or even exceeded, total returns in other sectors (I'll come to 2007-08 in a minute). In other words, bankers’ bonuses, even at their peak, did not undermine shareholders' returns. The caveat of course here is that shareholders failed spectacularly to see that those returns came with an unacceptably high leverage.

Coming to the 2007-08 debacle… Stock prices of financials were destroyed both in absolute terms and compared to other sectors! This called for drastic cost-cutting to preserve whatever shareholder value was left. And cost-cutting did occur. The industry shed 260,000 jobs within 12 months, bringing employment back to 2003 levels, with the obvious implications for the overall wage bill. And the bonus pool was down 45%.

Of course more could (and should) have been done. Still... the fact that bankers are losing their jobs by the buckets flies in the face of critics who claim that bankers take too much risk because they have too much upside and zero downside. In fact, let’s examine that argument in more detail…

4. Bankers take excessive risk because their downside is limited and, well… because they’re greedy!

OK, first of all, it’s the bankers’ job to take risk. We hire them to take risk, provided they can price it accurately and take an appropriate amount of it. Evidently, over the past several years a number of failures occurred and I won’t go into the “why’s”: Failures to price risk by the credit rating agencies; failures of bankers to conduct their own due diligence; failures of banks’ risk management units to raise the red flag; failures by the supervising agencies to evaluate the extent of systemic risk; and a Big Fat failure of ownership.

That’s right.. As I already pointed, shareholders failed to live up to the responsibilities that come with ownership, such as enforcing a system of checks and balances and a long-term vision for the firms they own. Instead they preferred to dance while the party was on. Mind you, not just the owners of banks. Everyone partied and nobody wanted to stop.

Given that environment, bankers—each on their own—behaved optimally: They took risk to maximize shareholder value and, in the process, enrich themselves, but not only. They also enriched the homeowners, the states’ tax coffers, the retailers, the automakers, the oil exporters, the Chinese…

Call that greedy, for sure. But so were many others, not least those homeowners who borrowed against their newfound home “equity” to splurge on a life of home improvements and imported electronic gadgets. Both were excesses and both were equally undeserved.

5. The rich are getting richer and the poor poorer. Ultimately, much of the popular dismay has to do with a perception of a growing and undeserved income inequality. I sympathize in principle—I can’t see how society is served best with anyone pocketing $25 million annually, whether their name is Dick Fuld or David Beckham.

But I hardly see this as an argument for restricting executive pay. You don’t want to stifle the hope of the Texan policeman’s son that he can “make” it in life, whatever you might think about his definition of “making it”.

But… you would hope that whoever makes that kind of money would display some humility, in appreciation of the society that allowed them to be who they are; and/or their luck of being born in the kind of environment that put them on a one-way street to success. At the very least, you would expect them to be sensible enough to resist a bonus in a year when the world crumbled along with them.

Those who opted instead for the private jets and the $35,000 commodes deserve our collective kick in the butt. But that’s not because they’re bankers. It’s because they are inadequate human beings.

I rest my case.

Saving the Fed from itself

Among the priorities of the mega-plan to resurrect the financial sector should be measures to save the Fed from itself.

Yes, “save.” As in, protect its financial independence and allow it to pursue its mandate of maximum employment and stable prices without undue interference from Congress, the Treasury or, indeed, anyone eyeing a cheap buck.

(I take it we all agree that an independent central bank is good for macroeconomic stability… And that financial independence is critical for buttressing a central bank’s policy credibility.¹).

So here is the issue: Over the course of the past year, the Fed has set up numerous creative facilities to prevent a severe liquidity crisis from blowing up (entirely) our financial system. It has also acted as lender of last resort to a bunch of bankrupt financial giants that were deemed too big to fail.

In the process, the Fed has amassed a multibillion dollar collection of “stuff”, some of which toxic and already bleeding with losses. Not great for the Fed’s own finances.

But market risk is not the only source of Fed troubles. Political risk is another. For example… The Fed announced last week it plans to modify the terms of some of the mortgages which underly the residential mortgage-backed securities (MBS) the Fed acquired after bailing out out Bear Stearns and AIG. The modifications are bound to lead to losses for the Fed (though it’s hard to tell how big compared to the losses incurred if the homes were foreclosed).

Now this makes me a bit uncomfortable. Not that stemming foreclosures is not a laudable objective. It’s just that the composition of the Fed’s assets has become such as to invite requests (worthy or not) that are not only politically motivated, but have also the potential of weakening its finances.

The Fed’s purchases of Fannie and Freddie debt and MBS add to this problem. I’ve complained about this program already (here), partly on the grounds that Ben has too weak a case for picking housing as a recipient for Fed lending rather than, say, small businesses, ailing automakers or… me, for a $35,000 commode (with legs) I’ve been dying to buy.

But it goes beyond that. The MBS program subjects the Fed to more political interference and to potential losses. Why? First, it’s Fannie and Freddie we’re talking about: Our bankrupt mortgage couple! Until their status and finances are resolved, the Fed risks making losses on its MBS holdings.

Second, the accumulation of MBS in its balance sheet may complicate the conduct of monetary policy once conditions normalize. For example, “politics” may have a say as to the pace and size of MBS sales by the Fed, if these were deemed to raise mortgage rates “unduly.” Alternatively, the Fed could hang on to its MBS holdings but raise the interest it pays on banks’ excess reserves, to keep the price of credit close to target. But higher interest payments imply a cost for the Fed, again weakening its finances (esp. if higher rates result in capital losses on its longer-term MBS securities).

So what can be done about it?

Now, first of all, I myself have been crying for Bernanke to go out there and start buying toxic assets from banks’ books. The idea was to exploit the Fed’s flexibility to move fast, and its deep pockets, to finance a giant investment vehicle that would carve out the toxic assets form banks’ books. A TARP, in other words, only bigger and faster (and with a plan for capital refills at the same time).

The idea also was that, once there was an Administration in place that could actually make decisions, the Fed would transfer these assets to the government entity to whom it “belonged”—the US Treasury.

But the TARP as such never really happened and now the dialogue has advanced sufficiently to let Treasury take the lead. That is, take over (together with the FDIC) the cost of financing/guaranteeing the toxic assets and eschew the interim Fed intervention altogether.

In the same spirit, the Fed should transfer its toxic portfolios (from AIG, Bear, Citi, etc) to the “bad bank”/ Treasury. This would deliver it both from further losses and from any Congressional interference on how to manage these assets.

Finally we have the TALF. I can see the case for a TALF vehicle, financed by the Fed, if its mandate is to provide interim liquidity to support lending to solvent borrowers, and to unwind its positions once liquidity is restored. But it should be managed independently, from both the Fed’s monetary policy and from Congress. As to MBS purchases, they could occur within this independent TALF framework, rather than under an explicit policy to support housing.

The Fed’s financial position may still be robust. But the changes in its asset composition are making it vulnerable to political interference, at a time when the political heat is rising. There is no reason for the Fed to engage in policies that would open the door to (or even call for) such interference.

In fact it shouldn’t! As Marvin Goodfriend wrote back in 1994, “the Fed should perform only those functions that must be carried out by an independent central bank.”

Credit allocation is not a “must” function of an independent Central Bank in a democratic, free-market society. The Fed should arguably stay away to avoid (due) challenges to its independence.

At the same time, measures should be taken to protect its independence when that's called for: The Fed should not bear the losses from the rescues of insolvent institutions (or of overvalued sectors such as housing). It should only be in the business of providing liquidity assistance to illiquid institutions. If such bailouts are deemed "socially desirable", their cost should be assumed by the Treasury.

So let’s get the mega-plan right, and free the Fed from what it shouldn’t be doing. That’s not meant to put Ben into a straitjacket... It’s to make sure he can keep on operating without one.



Glossary: Insolvent vs. illiquid, fiscal vs. monetary authority, political vs. financial independence, straitjacket

[1] For those in doubt about the need of central bank independence, you can start by reading the 1993 paper by Alberto Alesina and Larry Summers here. On the degree of a central bank’s financial independence and its impact on the credibility of its policies, you can take a look at a recent paper by Peter Stella from the IMF here.

Obama's bang for the buck

Obama’s economic recovery plan has begun to feel like the kitchen sink approach to fiscal stimulus. Anything goes... tax credits, spending on road repair, new computers for schools or the expansion of broadband access. And just wait for Congress’ inevitable “cherry on top”!

Interestingly, the bulk of the measures announced as part of the “American Recovery and Reinvestment” plan can be found in Obama’s pre-election promise on the future of the economy. But then, may I ask, is it a stimulus we’re getting or the entire economic agenda of the Obama-Biden ticket, only unfunded?

The latter, more or less. But let's go back to the beginning. Economic theory is not conclusive on whether discretionary fiscal stimuli can counter the impact of a downturn. (The IMF summarizes why here). By “discretionary” is meant anything over and above the “automatic” fiscal expansion that tends to come with recessions (e.g. as tax revenue falls and, say, spending on unemployment benefits rises).

Still. Since it’s easier to say you’re doing something, than to try to explain the meaning of an “automatic stabilizer”, here are a few guiding principles for discretionary fiscal stimuli:

First the three T’s:

• Timely (well, we’ve kind of missed the boat on that one, but let’s assume “better late than never” applies);
• Targeted—to get the money to those who need it most and/or those likely to spend it faster.
• Temporary—with clear sunset clauses to ensure debt does not go through the roof.

On top of these, the IMF threw out a few more in a paper last week:

• Lasting—the government should promise that the measures will last until the economic begins to recover, to reassure the public that it won’t abandon ship half way through.
• Diversified—since we’re pretty clueless about what works best, the IMF suggests trying a bit of every (wise) measure in the hope that some will work.
• Sustainable—again, to avoid the undesirable consequences of skyrocketing debt, such as higher interest rates, inflation and loss of confidence.

The idea behind all of these is, of course, to get the biggest bang for the buck.

So how does Obama’s plan fare? I’ll focus on the bigger items:

Income tax cuts: A $500 rebate for individuals and $1,000 for families, first stage of Obama’s electoral promise to cut taxes for 95% of American households. Targeted? No (95%!). Temporary? No. Bang for the buck? Perhaps, by virtue of being a permanent increase in disposable income instead of a one-off tax rebate that may be saved. Sustainable? I hold my breath (for at least a couple of years) till the cuts get funded.

Tax credits to companies for losses incurred in 2008 and 2009. An appealing idea, one might think—giving companies a bit of cash at a time when it has become a scarce commodity. But... The measure is highly distortionary, favoring troubled companies over profitable/better managed ones and, indeed, those least likely to hire or make new investments. Little bang for the buck.

A (refundable) $3,000 tax credit to companies for each new worker they hire: Hard to see how a temporary tax credit would dominate a bleak economic outlook in firms’ hiring decisions. So the measure is likely to be used (and abused) by firms who would have hired people anyway. Little bang for the buck.

How about Obama’s spending plans? Like, investments in alternative fuels, a new digital electricity grid or the expansion of broadband lines across America?

In theory, government investment has a bigger bang for the buck than tax/revenue measures: It has a direct effect on demand and long-term supply-side benefits (assuming it’s not spent on bridges to nowhere). In practice, lags in project execution and the difficulty in identifying good-quality projects soon enough makes it less effective in countering a downturn.

One way to increase the “bang” is to frontload the execution of existing, productivity-enhancing projects. This is partly what Obama said he plans to do, with $25 billion going towards the repair of roads, bridges and schools.

But how about the rest? Has the Obama team had the time to identify specific “worthy” energy/infrastructure projects that could start off as early as March? Are they indeed “worthy” enough for the private sector to take over/participate in their financing once markets stabilize? Or would the government need to keep up the subsidies till death do us part?

More generally, is Obama ready to commit, along with his “stimulus” package, to a medium-term budget framework? One that explicitly shows the meaningful reduction in spending (or increase in taxes!) that would be mandatory once the economy gets on its feet, in order to keep the debt at bay?

Ultimately, what creates jobs is confidence in a brighter economic outlook, and the availability of private financing at a reasonable cost to fund productive investments and create jobs.

A crucial step to this end is a credible commitment to keep the debt under control, at a time when (per the estimates of the Congressional Budget Office) the deficit will reach at least $1.2 trillion this year, before any stimulus plan is counted. Another is to fix the financial markets.

If you ask me, I’d rather see a much smaller stimulus package. One that focuses on safety nets (e.g. health and unemployment benefits to the unemployed); and on the effort to resurrect the financial markets and reduce the cost of private financing from its current obscene levels. Throw in some money to stem foreclosures for fairness’ sake, if you please. But beyond that, I’d rather see all the PhD talent of the incoming economic team devoted to designing appropriate structural reforms that improve the incentives of the private sector to function efficiently.

Meanwhile, Barack, if you’re having trouble with the meaning of “automatic stabilizer”, I can help with the speech. I promise to make it short, succinct and simple.



Glossary: automatic stabilizer, discretionary fiscal stimulus, bang for the buck

Ben's still dancing...

At first I thought I misheard… or that some charlatan journalist was trying to make headlines.

But no. Ben did say he's thinking of buying long-term Treasuries. His speech last Monday is crystal clear: “[T]he Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities […]”

Treasuries! Of all things! It’s like going to your favorite pastry shop, everything is at a discount, and you get a diet coke!

What’s wrong?

What is wrong is that this is the wrong solution to our problem, which is three-fold:

First, there is a huge hole in the balance sheets of banks, because a large amount of the assets in their books are either illiquid or junk or illiquid because they are junk.

Second, as a result of the first problem, there has been a brutal disruption in the availability of credit, as financial institutions hoard cash out of fear of each other, of nonbank firms and of their own ability to meet future obligations.

Third, the economy is on freefall, with the latest payroll numbers attesting to this (I’m looking for the superlative of “abysmal”).

So given these three aspects, what are the Fed’s priorities and objectives and what instruments will it use to achieve them?

Let’s start with the second, which is, ironically, the easiest part. By now, the Fed has established an entire infrastructure of facilities to address shortages of liquidity—the TAFs, CPFFs and ABCPMMMFs of this world. These are designed to be temporary, since the underlying assumption (and prayer) is that financial conditions will normalize.

That’s all good, only that along with praying, Ben’d better do something too. Like, deal with the first part of the problem, which is to plug the hole of the banks. What is he doing on that front?

It’s probably the Nth time I will argue “very little.” Yes, we had the use of part of the TARP (by the Treasury) to recapitalize some banks. Yes, we had the rescues of the selected few (AIG, Citi etc), partly with Fed money, to avoid a repeat of the Lehmans aftershocks. Yes, we had the announcement of the TALF, which was certainly a step in the right direction. But it has been very (very) patchy.

Take the rescue of Citi. It was last-minute. The modalities (fate of creditors, shareholders, etc) were a work in progress. No rationale was offered behind the amount of assets carved out of the bank (with the Fed's and the Treasury's help), including whether it would be sufficient.

Don’t get me wrong, it was the right “idea,” i.e. carving out assets on one hand, and plugging a potential hole with new capital on the other. But why not apply this approach uniformly and across the board of (systemically important) institutions, and clean up the system once and for all? And at the same time, prepare for the failure of institutions that (given our limited resources) we simply cannot rescue?

So let’s go back now to Ben’s idea of potentially buying long-term Treasuries. Clearly Treasuries are not really “toxic” (at least not yet!) and, as such, they’re not the kind of asset banks would like to see carved out of their books. So the purchases would do nothing to address problem #1 and, by extension, #2.

But then again, Ben really meant it as a potential means to address #3. Indeed, in his own words “This approach might influence the yields on these securities, thus helping to spur aggregate demand” (my emphasis).

Even here, this is not the most efficient use of Fed cash: First, long-term Treasury yields are super low already, so they don’t exactly need support.

Secondly, if there is any fear among investors that yields will go up in the future, that’s because of uncertainty over how inflationary of the Fed's easing is going to be—an uncertainty that is building fast, I should add, and which is not really dealt with by promising to, urh, print money to buy Treasuries!

Third, yields of, say, mortgages or loans to companies are high largely because banks currently demand a sizeable premium for liquidity (i.e. they’d rather hold cash or liquid Treasuries than lock their money on a long-term loan). This is not going to go away no matter how many Treasuries the Fed buys--unless the problems at banks get fixed.

So I’ll go back to my perennial call for the Fed to step in and buy a large chunk of the "troubled" assets in banks’ books. Like in the case of Citi, this should come in conjunction with a potential “refill” of bank capital, if the carve-out results in a new hole.

Buying toxic assets is better than buying Treasuries for another reason: IF the Fed is successful in revitalizing the economy, long-term Treasury yields are bound to go up (as growth expectations rise) and their prices would go down. This will translate into a large capital loss for the Fed.

On the other hand, if it buys the troubled stuff, success in rejuvenating financial markets will likely bring the yields of these securities down—at the very least because the "liquidity premium" will go down. Translation: The Fed could actually make a gain on at least some of these “toxic” assets.

Finally, let me throw another bombshell here--food for thought, you might say. This may be the time to revisit the desirability of an inflation-targeting regime for the Fed, of which Ben is a famous fan. Why?

Because uncertainty about future inflation is rising, as people get iffy about the expansion of the Fed’s balance sheet (which, by the way, is (still) non-inflationary for the reason I mentioned here). So this would be precisely the point where an explicit commitment by the Fed to a medium-term inflation target would help reign in inflation expectations.

Ultimately, what has been lacking all along is communication. Communication of the Fed's (and the Treasury's) accurate understanding of the size of the problem, their priorities and end-objectives, and the tools that will be employed to achieve them. We got one step forward last week, but Ben has now switched to foxtrot.

No offence, Ben, but it doesn’t look good! So why don’t you stick with the forward steps and let us do the dancing!


Glossary: troubled assets, cash hoarding, liquidity premium, communication, foxtrot.