On the demand side and the supply side: The stimulus debate

The flaming debate on how to steer the economy forward and avoid America’s “Japanification” has been dominated by two seemingly irreconcilable camps:

On one hand we’ve got the demand-side guys, who claim that Japan’s “lost decade” of the 1990s was the result of a spineless government policy reaction to the post-bubble reality... ergo the US can avoid becoming Japan by keep on stimulating itself with fiscal and monetary measures until private demand recovers.

On the other hand, we’ve got a bunch of supply-siders, who attribute Japan’s quagmire to the drop in Japan’s total factor productivity (TFP) 1/—a shock in the face of which demand-side policies are impotent.

The two schools of thought are irreconcilable only insofar as they are driven by the blind ideology of those expressing them; in economic terms, they are not.

Here, I’ll start form Japan and notably with the observation that TFP growth did in fact decline during the 1990s. (See here and here).

Now, while a TFP analysis may be useful in providing the breakdown of output growth into the contributions from labor, capital and TFP (ex post facto); it is not very useful in explaining why TFP may have fallen at any given period, let alone in forecasting how TFP might move in the future. The “why” has to rest on a comprehensive structural analysis of the Japanese economy over the past three decades, which is certainly beside the scope of this piece.

The key point here is that the observed drop in Japan’s TFP during the 1990s does not have to be exogenous (to policy). Indeed, plausible explanations as to why, allow for both the supply- and demand-side frameworks to have been at work simultaneously.

One such explanation has to do with the weak state of the financial sector after the bubble burst, and the concomitant misallocation of credit to inefficient, loss-making industries The link from bank weakness to credit misallocation goes like this: Troubled bank rolls over loan to troubled firm to avoid the pain of realizing losses on that loan. Troubled/inefficient firm remains alive for too long. TFP drops. (see here).

Japan’s story can also vindicate supply-siders, however. As highlighted in a recent speech by the Bank of England’s Adam Posen (a vocal demand-side guy), Japan’s TFP growth during 2002-08 actually exceeded that of major advanced economies (the US included). Posen presents this as evidence that Japan’s potential growth was not permanently damaged by the chronic recession.

Interestingly, part of the explanation he offers has to do with (supply-side) “structural reforms undertaken over the course of the 1990s. These included, energy market deregulation, some better utilization of women in the workforce, new entrants in retail due to the rise of Chinese and Asian production and telecoms deregulation [..], as well as financial market liberalization”.

Posen adds that “[w]hat was necessary [my emphasis] was the clean-up and recapitalization of the banking system, the further loosening of monetary policy […] and the avoidance of any further premature fiscal tightening”.

Why “necessary”? One can find the answer in that same speech: Protracted periods of recession, unemployment and financial sector weakness can lead to a destruction of an economy’s production potential. Those who stay out of work for a long time lose their skills, at the cost of lower future productivity; banks that remain weak for too long impede the allocation of resources to productive firms, per the storyline above.

As Posen states, “this is why a number of central bankers, myself included, have argued for very strong immediate response to negative shocks, so as to forestall this process insofar as possible”. In other words, fiscal and monetary stimulus policies should be geared towards preserving and expanding the economy’s production potential, while the private sector remains on the defibrillator. This is particularly relevant for the US today, where (per the latest Bureau of Labor Statistics report) the TFP of the private nonfarm business sector grew by just 0.1% in 2008—the slowest rate since 1995.

So what measures fit the bill? On the fiscal side, tax breaks for companies that retain their workers during a recession (as in Germany) or programs to build up the skills of the long-term unemployed (whereby private firms would receive government support for training unemployed workers) would be more effective for safeguarding the economy’s productive potential than the mere extension of unemployment benefits.

Similarly, programs such as the first-time homebuyer credit (not to mention the multibillion dollar transfers to Fannie and Freddie) were a complete waste of taxpayer money: They provided a boon to people (with jobs) who could afford to buy a house; and they artificially supported house prices (at least temporarily) at a time when the average American household is still enjoying a substantial positive equity in its home. Instead, fiscal policy should have focused on measures to relieve those households with negative equity in a permanent way and stop the vicious circle of foreclosures-price declines-more negative equity-more foreclosures and so on.

On the monetary side, I am planning to write a more comprehensive piece but my theoretical framework is one I already laid out here. As a “preview”, the Fed wasted the sense of urgency prevailing back in March 2009 by going after the wrong type of assets (MBS) in its asset-purchase program.

So where have demand-side fanatics fallen short? In that their prescription for fiscal and monetary stimuli is, basically, “bigger is better”. There is little link between the size, type and duration of stimulus measures and the objective of safeguarding and promoting the economy’s productive potential.

Ultimately, it is hard to disagree that accommodative monetary and fiscal policies can help an economy during a recession. The question is what measures are the ones that will help the private sector reach what Larry Summers called “escape velocity” without undermining the commitment to medium-term fiscal discipline. “Not enough” is not economics; it’s a political statement.



1/ For the uninitiated, TFP measures the impact on output of technological change, reallocation of resources, economies of scale, etc after taking into account the amount of capital and labor inputs that go into the production process. (In other words, it’s the output per unit of joint labor and capital inputs).


PS And yes, I'm back after a long summer Odyssey!

An Ode to Crisis Economics

Reading through Nouriel Roubini’s new book, “Crisis Economics”, is like tasting a sample of what Nouriel does best: Explain economics in such straightforward English that makes the intricacies of the dismal science feel like an effortless walk in the park.

The team up with Stephen Mihm, a history professor (and journalist), adds a nice breeze to the walk by garnishing the analysis of the recent credit crisis with a barrage of all-too-similar parallels from the past—a reminder that financial crises are “creatures of habit”, “the norm, not the exception”, an inevitable consequence of human psychology and behavior.

The reader is basically taken by the hand and given a comprehensive tour of key milestones in financial, political and regulatory history that contributed to the subprime crisis: From the origins of securitization; to financial de-regulation; to government policies to encourage home ownership; to the emergence of shadow banks; to the global savings glut and the build-up of leverage; and, finally, the “Minsky moment.”

Equally effortless is the walk through the crisis itself and the vast array of policies undertaken to address it. In what amounts to a series of “crash courses” in every aspect of crisis economics, the reader is rewarded with all sorts of gems:

An exhaustive account of the channels of crisis-contagion, from trade, financial and labor linkages to the currency and commodity markets; a comprehensive cataloguing of the fiscal policy toolkit to fight financial crises—from the conventional (cut-tax-spend-more) to the unconventional (guarantee, bailout and recapitalize); or (my favorite!) colloquial English explanations of such esoteric economic jargon as the “liquidity trap”: “You can lead a horse to water, but you can’t make it drink.” (Just replace “horse” with “banks”, “water” with “cash” and “drink” with “lend”).

For this alone, the book is indispensable reading not just for students of economics but also for any non-specialist who has the slightest curiosity to understand why all hell broke loose back in August of 2007.

Nouriel’s tone changes when it comes to policy prescriptions. Here we no longer hear “Roubini the cool minded professor” but the passionate, militant and, often, unedited policy commentator he has recently become known for. (“[..] banks have been able to pretend that their crappy assets are worth far more than any sane assessment would suggest.”)

The prescriptions offered cover a wide range of policy areas and are worth the read, not least because they give a taste of what has been an intense debate among academics, policymakers and market participants about the way forward. So here I’ll just focus on two of the areas where I felt readers were left asking for more.

The first has to do with putting a theoretically appealing framework for crisis resolution into practical use. According to the authors,

“[..] it makes sense to follow the playbook devised by Keynes in the short-term, even if the underlying fundamentals suggest that significant portions of the economy are not only illiquid but insolvent. In the short-term, it’s best to prevent a disorderly collapse of the entire financial system […].

But when it comes to the medium and long term, the Austrians have something to teach us. [..] In the long term, it is absolutely necessary for insolvent banks, firms and households to go bankrupt and emerge anew; keeping them alive indefinitely only prolongs the problem”.

Pragmatic and ideologically inclusive, but… the question is how to identify the point of transition from the “short” to the “medium” term, including in the current crisis. From the tone of the discussion about the looming dangers of public over-indebtedness or the Fed’s bloated balance sheet, you would think that the medium term is already upon us—yet, the urgency for corrective action is hard to square with Nouriel’s view that we’re stuck well inside the belly of a U-shaped recovery for years to come.

Basically, we're missing a set of concrete signposts that would make policymakers confident that the timing for a switch from accommodative, crisis-management policies, to restrictive, structural measures is right. In its absence, the distinction between the “short” and the “medium” term feels as relativistic as the old adage that “old age is always 15 years older than I am.”

Turning to financial regulatory reform… Here the discussion turns so militant as to potentially undermine the credibility of the proposals put on the table (some of which make a lot of sense). What is missing in my view is a rational framework to support the various elements of reform (from bankers’ compensation, to capital requirements to addressing the too-big-to-fail problem). Instead, the discussion felt more like an account of “The Thousand and One Ways to Exterminate Goldman Sachs”!

As I’ve argued in the past, the starting point for financial reform should be a well-researched view on the appropriateness of the current competitive landscape in the financial sector—one that takes into account both economic efficiency (which calls for more competition) and prudential considerations (which, by some academics, might call for less). Reforms on bank size or even bankers' compensation should be an output of that framework, rather than autonomous ends in themselves.

Importantly, the call to separate commercial banks from broker-dealers, hedge fund operations, etc so that “only commercial banks would have access to deposit insurance and government safety net: Everyone else [..] would be on their own”, misses the point in my view.

First, because broker-dealers, investment banks, money-market funds, etc are equally systemic, given their critical role in intermediating finance for both companies and households. And second, because many of the services these institutions provide are very much bank-like—so the right way to go is to subsume them more effectively into the regulatory framework for banks. This should include a deposit-insurance-like scheme to internalize the costs of future bailouts.

“Crisis Economics” puts Nouriel right in his element. It may be easy to forget, amidst the “Dr Doom” clatter, the "ladies in waiting" and the Cannes appearances, that this is a guy who has made an enormous contribution to our understanding of crisis economics for years now—from analytical frameworks as valuable as the “balance sheet approach” to financial crises, to one of the most extensive accounts of addressing crises in emerging markets in his earlier book “Bailouts or Bail-ins?”.

The book also puts Nouriel in his element by demonstrating the huge breadth of his knowledge—from history of economic thought, to CDOs-squared to global economic governance. Indeed, the book’s most important lesson may be precisely this: That successful economic management must rest less on a compartmentalized edifice of knowledge and more on insights drawn from a holistic framework that includes history, economics, philosophy and, above all, common sense.

The good, the bad and the irrelevant

If I’m not mistaken, the Senate election last week was held not in Michigan, nor in Mississippi, but in Massachusetts: America’s highest-ranked state by health-insurance coverage and education, and the third-highest by per-capita income.

If I’m also not mistaken, the winning candidate lured voters not with his ruthless bank-bashing (on the contrary!), but by flagging himself as an “independent” with a (supposedly) fiscally conservative agenda.

Against this backdrop, the knee-jerk reaction that came out of the White House shortly after Tuesday’s results is not just bad (polarizing, desperate) politics; it’s also bad policy—irrelevant and potentially harmful policy.

Starting with irrelevant: The proposed “Volcker Rule”, which would prohibit banks “to own, invest or sponsor hedge funds [or] private equity funds” or engage in proprietary trading does exactly nada to address the causes of the financial crisis. These were:

(a) the inability of banks and their regulators to grasp, let alone contain, the level of systemic risk resulting from their highly leveraged operations;

(b) abundant liquidity, easy credit and the search for yield (call it greed if you like); and

(c) as a result of (a) and (b), too little capital to support the ballooning debt in the financial system and the real economy (esp. households).

Constructive initiatives to address systemic risk and capital adequacy are already underway, with high-level institutions like the Bank of International Settlements preparing proposals in these areas. These would include more effective and transparent rules for loss provisions, pro-cyclical capital buffers, a resolution framework for “too big to fail” institutions and stricter liquidity requirements.

What does the Volcker Rule add to this discussion? What… you said more protection to the taxpayer from the high risk takers?! Well, no.

Basically, the Volcker “rule” is grounded on an erroneous assumption: That only institutions that receive deposits from the man on the street are worth stabilizing with taxpayer money (e.g. through deposit guarantees) because of their special role in economic growth.

But this is clearly misplaced. Non-bank financial institutions such as money market funds, finance companies and securities lenders/dealers are absolutely instrumental for the flow of corporate finance and household credit. As such, they are very much “systemic” from an economic growth point of view. One can only recall the complete meltdown of the US and the global economy when Lehman was allowed to fail! Lehman was not a "bank"—yet it warranted an orderly resolution, which—at that stage—had to risk taxpayer money.

In light of this, the relevant policy response is not to --effectively-- force financial institutions to make a choice between their deposit-taking (ie banking) services and their "non-bank" activities. Instead, it is to recognize that what are seen as "non-bank" services are often very much "bank-like" and should be regulated approrpiately with the view of promoting sensible risk-taking across the balance sheet.

By "bank-like" I mean, first of all, maturity transformation. Take finance companies: They borrow short-term commercial paper to invest in instruments like mortgage-backed securities, which are backed by long-term assets. That's not far from plain vanilla banking. I also mean liquidity services: For example, securities dealers take deposits from their hedge fund customers, which are redeemable on demand, but then use the cash to fund their activities in credit market instruments whose liquidity can dry up instantly. This prompts funding uncertainties and a potential run on the dealers... and thus needs to be addressed.

Yet, rather than a targeted regulatory proposal, we get the Volcker rule--a waste of precious political capital and resources for a measure that is ultimately irrelevant!

Then you have the greed problem—and a problem it is! But containing it requires effective regulation, not populist one-off measures (which can backlash).

So what type of regulation can be effective in reining in greed in executive pay? Once again, some initiatives are already underway. The Federal Reserve for example has made a set of recommendations to better align incentive compensation with the risks undertaken by financial sector employees and also with their long-term performance.

But more may need to be done--if, for example, high executive pay turns out to be the by-product of an unduly monopolistic environment in the financial sector, which in turn leads to abnormally high earnings. Indeed, as I argued here back in November, a comprehensive assessment of the benefits and costs of the financial sector’s existing market structure and the identification of measures to improve it should be a top policy priority.

Yet, what we get is a bank tax! OK, may-be one can justify it by the extraordinary, government-backed recovery in financial markets and the, admittedly, business-as-usual attitude by some banks in the sphere of bonuses until it was too late. But it may also end up being harmful: If competition in the financial sector is limited, banks will have the market power to pass on the cost of business to their customers! And this can’t be good for lending nor for the economy more broadly.

Beyond the irrelevance of the proposals, what is far more disappointing is the new tone coming out of the leadership. Here you have the sober, Harvard-educated President, who excited many an independent voter with his intellectual approach to politics and policy back in 2008, employing an increasingly populist vocabulary.

Not only does this alienate independents further. It also raises the level of political risk for businesses and the markets, undermining the one visible achievement this Administration can claim credit for: The restoration of some sense of stability and order in financial markets and, with it, the recovery of a substantial amount of households’ financial wealth and confidence more broadly.

It would really be a shame if the (mis)reading of an electoral outcome ignited a policy agenda that is ill-focused, time-consuming and potentially unsettling. One can only hope it’s not too late to change tack.

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.

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!

Time to ditch the PPIP

You know the world has changed when you go out for a drink with a banker (from the “legendary 19”) and he orders “anything without government in it”! Out of curiosity I seconded the order, and we both received a commiserating look and a vodka tonic.

Anyway, the topic du jour is the PPIP… Revisited after several rounds of thinking, as well as conversations I had with a (small) sample of eligible buyers and sellers. And I am convinced more than ever that the scheme has become useless.

I mean, literally. First of all, in the post-stress test era, I’m having trouble to understand why we need to subsidize investors with taxpayer money to bid up the prices of the banks’ legacy assets.

Think about it… IF (big IF) we were to take the results of the stress tests at face value, banks are fine (we are told), provided they can raise the amount of capital they were instructed to, privately or otherwise. This is because the stress tests have already taken into account the expected losses on banks’ assets (over 2 years), including the “legacy” ones, even under an extremely bad scenario.

But if that’s so, banks shouldn’t need additional help in the form of artificially high bids for their legacy assets. At best, they could sell them to the private market and fetch prices consistent with the government’s own analysis. At worst, they could keep them in their books for a couple of years, possibly more, and still be comfortably capitalized and ready to lend to businesses, mortgage borrowers, you and me. So, why PPIP?

One reason could be that the stress test results are a joke. But let’s not be so harsh… Even if the stress tests results are sound, the PPIP might still be useful if it could facilitate the process of “price discovery” for the legacy assets. But this is not the case.

The whole point of providing private investors with cheap government money is to encourage them to bid up the prices and help bridge the gap between what sellers would love to receive and what buyers would be prepared to pay in the current market conditions. (The idea is to avoid having sellers incur massive losses that could force the government to acquire unacceptably high equity stakes in banks and be accused of the N-word.)

But this is not “price discovery”. It’s a subsidized purchase. As such, it will do little to catalyze market activity in banks’ illiquid assets more broadly, since buyers will not risk bidding high for assets that are not covered by the government’s funding. It is even questionable whether investors would be willing to take the risk to buy securities with maturities longer than the government’s funding.

Ironically, price discovery is happening already in private markets, at least for some “legacy” assets. I am not in this field so what follows is anecdotal, but I understand that at least some “legacy” securities and even loans are being sold and bought as we speak.

Indeed, if you want to see price discovery, you might not have to go further than the sales of loans and securities conducted by the FDIC itself! These are asset sales on behalf of the numerous banks that have been going bust every other Friday or so and that the FDIC (shhh!!) nationalizes before turning them around and re-selling them to new private owners.

True, the prices fetched may not be prices that the FDIC (or the taxpayer, for that matter) likes. But the merit is a swift turnaround of the failed banks, which can then be run by new (better) owners and start lending again. At the same time, the “legacy” loans are passed on to investors with better expertise in distressed assets, loan work-outs and the like, who should be able to maximize the value of these assets (sure, for their own benefit, but also at their own risk!)

Then you also have the problem with the sellers. I mean, what’s in it for a seller? Oh, really? Higher prices? But take a look at the cost…

First, per my fellow drinker’s quote, eligible sellers loathe the idea of having anything with “government” in it. So that’s the starting point. The question is, is there anything that can incentivize them to participate anyway?

Well, one could be the government’s stick. But how strong is that stick? Post-stress tests (and related recapitalization), the government’s case for forcing banks to sell their illiquid assets has become weaker.

Beyond that, the incentives are few to none, especially in the absence of forced collective action. The reason is a big free-rider problem: An individual bank has every incentive not to sell anything, and wait (hope) instead that the participation of the other banks in the PPIP will improve financial market stability and lift asset prices more broadly. At which point, it will go ahead with its own sales, benefiting from the PPIP without having to bear the brunt of Congressional oversight or the public’s wrath for its taste for private jets.

So is there a solution?

Frankly, my preference has been, since time immemorial, for a fully government-owned vehicle to take over banks’ illiquid assets swiftly, at close to “market” prices (or at least prices consistent with a given probability distribution of economic scenaria).

The government could then manage these assets to maximize shareholder (taxpayer) value. Management would include, of course, selling these assets in an orderly fashion to private investors—only that taxpayers have all the upside (and the risk, of course, but they bear most of the risk now anyway).

This never happened because of concerns about heavy writedowns and concomitant bank nationalizations. Fine. But post stress-tests, the landscape has changed: The government’s case for a taxpayer subsidy to banks and investors is weak, especially as banks have been raising capital in private markets and trying to issue debt free of FDIC guarantees.

So maybe it's time to ditch the PPIP and let buyers and sellers sort things out privately, including bank recapitalization. If the latter becomes forbidding for some banks, the taxpayer can step in, with all the strings attached to maximize taxpayer value but also with the due arms-length approach to bank management that allows that value to flourish (something that is not happening right now in some cases).

Ultimately, you can't satisfy buyers, sellers and taxpayers all at once--something has to give. In my world, sellers are forced to take action (as in writedowns), but with the promise of a predictable, reliable and prosperous field ahead for private enterpreneurship (and bonuses!).

Because if there is anything all three groups agree on is the following: Nobody likes to have the government meddling in their affairs!

The Resilience(?) of the American Consumer

With all the hype about green shoots, “reassuring” stress tests and stock markets rallies, not to mention the fabulous New York weather, I felt a sudden urge to go shopping!

Yet, except from a birthday present and the obligatory ticket to Star Trek *The Movie*, I couldn’t do it… I still have trouble convincing myself to splurge on anything that I can’t eat.

Just to double-check I don’t suffer from some kind of acute post-crisis hoarding syndrome, I had a look at the data to see how far (or not) I stand from the average American consumer.

In fact, the point of the exercise went beyond my own syndrome-check: The green shoot story rests partly on the view that the liquidation of inventories we have been witnessing for the past year and a half will have to give way to a re-building of stocks—read production! I mean, there are only so many times you can go to BestBuy and look for your favorite laptop in vain, before you start screaming at management.

But here is the catch… for this to work, you must want to buy a new laptop in the first place! In other words, demand must remain robust enough to encourage inventory re-building. And consumption is a big part of demand. So how resilient is the American consumer?

The data are actually pretty mixed. After consumers’ effective “abstinence” from anything and everything in the last months of 2008, first-quarter personal consumption increased 2.2% in real terms, stirring optimism about the ability of the American consumer to steer us out of the crisis.

But the optimism may have been premature. Indeed, speaking of laptops, part of the growth was due to a 9.4% increase in the consumption of durable goods—electronics, refrigerators and the like. While this might have reflected pent-up demand “post-abstinence”, some (cynics, surely!) pointed out that the surge in durables consumption could actually be related to the liquidation of Circuit City back in January.

The bears (sorry, cynics) got another boost today, after disappointing retail sales for April, and downward revisions for March, which doesn’t bode well for consumption growth this quarter.

“Surprise surprise”, you might say.. with unemployment hitting 8.5%, wages falling in real terms and wealth being destructed as house prices continue to collapse, no wonder consumption is falling. After all, in the long-run, consumption is driven by the level of income and wealth, no?

Actually, the picture is less clear-cut. First, because American consumers are getting a LOT of support from Uncle Sam. Just to give you an idea, households, on aggregate, saw their labor income decline by $15 billion in the first quarter, together with a near $25 billion drop in their income from housing and financial assets. That’s $40 billion down in a quarter!

But on the other side of the “equation” was a whopping boost from the government, in the form of transfers and lower tax payments—some $70 billion in total during the same period!

A hefty part of this reflects “automatic stabilizers” at work—e.g. as labor and investment incomes fall, tax payments drop too; similarly, as unemployment rises, this prompts larger transfers from the government to those who lost their jobs. These should continue to mitigate the drop in disposable incomes while the economy remains weak.

Then we have the stimulus package, which has already come on stream. I’m talking about measures like the Making Work Pay credit and the Social Security Economic Recovery payment, which should add around $55 billion to disposable incomes this year—a big chunk of which in the second quarter. And of course you have the Fed trying to fight a rise in long-term rates, which, IF it succeeded (big IF), could help create more room for spending for households that manage to refinance their mortgages at lower rates.

Uncle Sam regardless, there remain a few question-marks here, especially when one looks beyond the second quarter.

The first is a technical one: The dollar-for-dollar analysis above is not entirely appropriate for assessing the impact on consumption—if for nothing else, for focusing on aggregate numbers. For example, part of the drop in income taxes is due to lower taxes on interest income and capital gains. But the people helped by this decline may not be the same ones who lost their jobs and/or are cash constrained. On the other hand, to the extent transfers are well-targeted, they are more likely to be spent.

Another question mark has to do with the impact of “wealth effects” on consumption. The argument goes that the unadulterated destruction of wealth over the past year should force consumption down to more “sustainable” levels. This is because, at the moment, the level of personal consumption relative to income is still way above what might be predicted by a long-term equilibrium relation between consumption, disposable income and net wealth. So, surely, consumption should correct, right?

Well, not exactly. You see, for the long-run equilibrium to be re-established, the adjustment doesn’t have to come from the consumption side—it could also come from income, from net wealth or from all three. In fact, as a NY Fed paper argues here, historically most of the adjustment has come from the wealth side, while very little has come from consumption. In other words, consumption has not over-reacted to short-term wealth exuberance but has been slower to adjust by responding instead to “permanent” changes in wealth.

I recommend the “braver” readers of this blog to read the paper itself, but my bottom line here is that the impact of the recent wealth destruction on consumption may not be as severe as many analysts fear. The one caveat I should mention, however, is that, in this recent cycle, many households perceived the increase in their housing wealth as permanent, to the point that they even borrowed against it. The result may have well been a more rapid than "due" rise in consumption that now has to adjust downwards.

The third question mark is probably the most relevant for the consumption outlook (not least because it’s the most relevant for my own consumption pattern!). It’s called labor market or, rather, labor market UNCERTAINTY. With unemployment still on the rise, real wages will likely continue to decline, while job uncertainty will be a drag on consumer spending: I may have survived N rounds of layoffs, but if I think there might be round N+1 (or more) I’ll simply refuse to splurge.

Finally let me throw a “bonus” question mark, which is the potential (downward) impact on consumption from uncertainty about the tax regime going forward, especially as fiscal deficits are forecast to rise and debt sustainability (if we still believe in such a thing) will require higher taxes in the future.

If there is a bottom line in all this is that the American consumer may be more resilient than some headline numbers suggest, e.g. when it comes to wealth effects, but will likely require life (read government) support for months to come, barring a surprise recovery in the labor market.

I guess it’s exactly the moment when Spock’s legendary salute would be most welcome: “Live long and prosper!”

Between the lines

If you were looking for a proof that the IMF needs to revamp its communication tactics, and/or that (some) journalists need to learn how to read, you need to go no further than the Fund’s $4.1 trillion estimate of the global losses in the financial sector.

The number sounds staggering, even compared to the IMF’s own estimate back in October 2008, which had losses on US-originated loans and securities at roughly half the size of the current estimate. Which is why I find it all the more puzzling that the Fund chose to flash it on the front page of its WEO/GFSR introduction, just like that, without any qualifiers.

Starting with what the $4.1 trillion is really about… or what it’s not. So, it is not the net cost of the collapse of the global financial sector. In estimating writedowns on securities, the Fund used current market prices and spreads of relevant credit market indices. But according to the going wisdom (including the IMF’s), these market prices overstate the actual default rates that we are likely to see in the underlying loans, due to “abnormal” funding constraints faced by market participants.

The IMF’s own numbers reinforce this point. For example, market-implied loss rates on US-originated commercial mortgage securities are shown to be 35% on average. This compares to the Fund’s own estimate of 9.8% for commercial mortgage loans, which was derived based on a model driven by fundamental factors such as lending standards and real private consumption.

In other words, the writedowns for the securities (almost $2 trillion out of the $4.1 trillion) do not reflect the “fair” (fundamentals-driven) value of the securities, which would be realized once the securities mature. In fact, in what is admittedly a very crude analysis, the application of the Fund’s own estimated loss rates on the securities portfolios would reduce the projected writedowns by $830 billion.

Journalists’ headlines regardless, the Fund never actually said that the $4.1 trillion is the estimated net loss to the financial system. The purpose of the exercise was a whole different one: To use the results as an input for deriving the capital hole in the banks of the major global financial centers.

So what do we get? Well, for starts, the $4.1 trillion reflects the potential writedowns for the entire financial system, including hedge funds, pension funds, etc, i.e. not just banks. The relevant number for banks is $2.47 trillion globally.

So far so good. Then we get the “Bank Equity Requirement Analysis” (here), which breaks down the capital hole by region. The hole, of course, depends on (a) the losses each country or region will likely experience; and (b) the existing capital cushion (if any) that banks have to absorb these losses.

Here things become a bit unclear. First, the numbers don’t exactly add up. I mean, where is Japan?? Somehow, the Fund suggests that the entire $2.47 trillion of writedowns will be borne by US and European banks—i.e. that Japanese banks had the foresight to avoid every bit of toxic asset originated elsewhere, and even to pass on the entire stock of their own toxic loan and securities to those American and European fools. Impressive, if one believed it…!

Importantly, we have the striking difference between the capital ratios of Eurozone and US banks—with the former looking much more unfavorable than the latter, even before the bulk of the writedowns begin. But it's a well-known fact that different accounting standards in Europe and the US (IFRS vs. GAAP) tend to overstate the leverage ratios of European banks, compared to what would have been under GAAP, because IFRS treats derivatives on a gross basis rather than net. I am not saying that European banks are hale and hearty—only that the numbers used by the Fund are not comparable and, as such, are likely the wrong starting point for calculating the capital hole.

I don’t want to downplay the cost of the financial crisis which, however one looks at it, is astounding and grossly unfair to those who played by the rules. But we are in the middle of the stress test season, and catchy numbers can become counter-productive if interpreted by a hasty pair of eyes.

My own pair of eyes see a simpler message.. or two. One is that we have a long way to go in restoring capital adequacy, though perhaps not as long as the Fund suggests, given the caveats above. Another is that estimating the capital hole involves as much art as science. So let’s hope markets don't find the art too abstract for their taste…

Sayonara Japan, Hello America!

After Geithner’s earnest declaration that “we are not Sweden” I felt compelled to go back and read through the details of past banking crises just to see what makes us so different. Following which, I fear our Treasury Secretary will have to make a bit more effort to convince me how we are going to avoid becoming Japan.

The parallels have been drawn many a time, including in a fairly recent NBER paper, whose eerie timeline of Japan's steps to resurrect the financial sector left me wondering: Is it short memory, self-denial, inflated egos or what, that’s driving our own policymakers into trying to reinvent the wheel?

I’m not going to go through Japan’s measures one by one (I strongly recommend reading the NBER paper for that). I want to focus instead on how to avoid repeating Japan’s mistakes in dealing with banks' undercapitalization problem. So here we go:

What to aim for: Let’s start with a vision… One of the most interesting parts of the paper (for me) is its discussion of the Japanese authorities’ disregard of evidence of “overbanking” and a need for consolidation in the sector.

“Instead, the only objective that was pursued forcefully as part of the recapitalization was that banks were required to increase their lending, especially to small and medium firms. The recapitalized banks were required to report the amount of loans to small and medium firms every six months.”

The parallel with the US is clear: The US approach up till now has lacked a vision with regard to the desirable size and structure of the banking system. If anything, the authorities plan to make it bigger by providing subsidized leverage to what would effectively be new “banks,” while “old” banks unload their burdens so that they can go ahead and… lend more.

Some have countered that before you get to repair the Titanic, you have to prevent it from sinking. Maybe. But to take the analogy further, to me it looks like we are wasting our efforts unloading our “family gold” into the ocean, instead of employing some of our limited resources to plug the holes.

Put it differently, (and as in Japan), the rescue efforts have been (and are being) applied to all institutions indiscriminately, without careful auditing to assess each financial institution’s health or the outlook of its future viability.

Think of the Treasury’s Capital Assistance Program, which applied to the “selected” institutions on a mandatory basis, needed or not; or the PPIP which is designed to benefit whichever bank has assets for sale, regardless of whether some banks may eventually have to fail. Not to mention the billions already wasted on AIG.

If the current course of action were to continue, the outcome would look like this: A recapitalization that is too small to solve the problem; yet too large by any standard of social equity and fairness. A banking sector that is too large to be sustainable without meaningful consolidation. And a bunch of carcasses left in banks’ books, as banks eagerly wait for a turnaround in the markets to lift asset prices and help them close their (true) capital hole. Japan all over.

Here is a better approach, building on the Japanese experience:

Step 1: “In Japan the recovery started with the toughening of the regulatory audits.”

Frankly, I don’t see (the substance of) why the authorities have been resisting conducting an evaluation of banks’ health on a mark-to-market basis. The taxpayer is in with his wallet either way, whether it’s in the form of new bank capital or of subsidized funding to private participants in the PPIP, TALF, etc.

But still. The point is that we need a consistent and transparent process to estimate the size of the capital gap in each bank. If mark-to-market is a non-starter, the estimates could be based on the valuations of the so-called “Third Party Valuation Firms”, i.e. the entities used by the Treasury to assign preliminary prices for the pools of assets banks put for sale under the PPIP.

(Incidentally, I don't think the stress tests can do the job, and you can see here why. Neither will the PPIP, but I’ll have to discuss why in another post).

Step 2: “[..] the 1999 recapitalization, together with the introduction of a scheme for orderly closure of systemically important banks through nationalization in 1998, ended the acute phase of the banking crisis.” (my emphasis)

Just to clarify, this is not (necessarily) a call for nationalization, but… For me, one of the most positive developments coming out of the Treasury has been the government’s request for authority to take over systemically important financial institutions at the brink of default (see here). If granted, it could be a powerful tool in helping execute the government’s vision (to the extent they develop one) as to the desirable/feasible size of the banking system, by allowing the (orderly) wind-downs of weak institutions, including systemic ones.

Step 3: “One important ingredient were the changes initiated in late 2002 and early 2003 at the behest of Heizo Takenaka, who […] called for (1) more rigorous evaluation of bank assets, (2) increasing bank capital, and (3) strengthening governance for recapitalized banks” (my emphasis)

The Administration’s attitude towards bank governance has been gentle at best; yet it should be a core element of a comprehensive bank strategy. I continue the quote:

“In August 2003, the FSA also issued business improvement orders to fifteen recapitalized banks and financial groups, including five major ones (Mizuho, UFJ, Mitsui Sumitomo, Mitsui Trust, and Sumitomo Trust) for failing to meet their profit goals for March 2003. They were required to file business improvement plans and report their progress each quarter to the FSA.

UFJ Holdings was found to have failed to comply with its revised plan in March 2004 and received another business improvement order. The CEOs of UFJ Holdings, UFJ Bank, and UFJ Trust were forced to resign, and the salaries for the new top management were suspended. The dividend payments (including those on preferred shares) were stopped. Salaries for the other directors were cut by 50%, their bonus had already been suspended, and the retirement contributions for the management were also suspended. The number of regular employees was reduced and their bonuses were cut by 80%.”

I am personally encouraged by the Administration’s decision to take a tougher line on GM and I can only hope that it adopts a similar approach towards banks—involving changes in banks’ management and the requirement for business restructuring and viability plans.

As a concluding note, here is another quote from the paper:

“The main problem with the Japanese approach was that the banks were kept in business for far too long with insufficient capital. This limited the banks willingness to recognize losses and they took extraordinary steps to cover up their condition and in doing so retarded growth in Japan. The U.S. policymakers seem to appreciate that this was extremely costly and appear to be trying to avoid it.”

Let’s hope that America's efforts to avoid Japan's mistakes go beyond “appearances,” because the similarities are too scary to allow us to imagine a different outcome.

Back to square one

This may not be news to those who have recently tried to raise money for their small business, refinance their mortgage or entertain a family shopping trip only to opt for a game of charades, until they feel a bit wealthier… Financial conditions feel tight!

What might be a surprise is that they are even tighter than six months ago—despite the Fed’s 1.75% worth of rate cuts to practically zero and despite the doubling of its balance sheet over the same period! Basically, we're back to square one and, if I were to guess, Ben must be having trouble sleeping.

The concept of “financial conditions” is an extension of the framework of “monetary conditions” used by a number of central banks to monitor how tight or loose monetary policy is. (As recently as last week, the Swiss National Bank cited the “inappropriate tightening” on monetary conditions as one of the reasons behind its decision to depreciate the Swiss franc to help loosen up things).

The general idea is that the focus on a central bank’s target interest rate is too narrow to capture the overall financial conditions in a complex economy. For example, in the US, where capital markets have been increasingly important in allocating capital, monitoring stock and bond market variables is essential for assessing the outlook for private investment and even consumption.

Of course you’d think these variables are closely linked to the Fed’s target interest rate—courtesy of the monetary transmission mechanism, whereby changes in the Fed’s policy rate are eventually reflected in asset prices across the board and across maturities.

But that’s precisely why a financial conditions index (FCI) can be very handy when the transmission mechanism is broken (read “today”) and/or the Fed’s policy rate is zero (read “today” again). In such an environment, an FCI framework may be the only way to monitor changes in the monetary stance, its impact on the growth outlook and whether the Fed should do more.

Which brings us to the numbers.

Bill Dudley, current president of the New York Fed, came up with a Financial Conditions Index for the United States back in the 1990s, during his stint at (where else?) Goldman Sachs. (You can see one of his early exposes on the index here).

Goldman’s subsequently refined the index but the basic principles remained the same: The index is a linear combination of four indicators: The short-term interest rate (the three-month LIBOR rate); a long-term reference rate to reflect borrowing costs for corporates (the 10-year US Treasury plus the ten-year CDX spread, which tracks the cost of protection against the default for a basket of US companies); the US dollar trade-weighted exchange rate; and the S&P500 index to capture equity prices.

In case you were about to ask, the intuition behind including the exchange rate is to capture the adverse impact of a real exchange rate appreciation on the demand for domestic goods. The rationale for including equity prices is, as Dudley explains, to capture the impact of movements in stock prices on household wealth (and thus consumption) and on corporate investment (via the impact on the cost of capital).

So what do the numbers tell us? After reaching a low in May ’08, Goldman’s index has seen a relentless increase ever since (i.e. conditions are now tighter). This is not that surprising in light of the collapse in equity prices, the rise in corporate spreads and the reversal in the fate of the dollar, which has strengthened sharply since last July.

But worryingly, the index is somewhat higher than back in October, despite the Fed’s rate cuts and despite its numerous acronymed facilities to support financial intermediation.

Unfortunately, the situation may be even worse than Goldman’s numbers suggest. As Dudley acknowledged back then, the index is not designed to capture the availability of credit (i.e. the quantity, rather than the price, of credit). But this can be extremely important.

Indeed, its importance is highlighted in a more recent paper by Andrew Swiston at the IMF. Swiston uses the results of the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) to create a measure of credit availability. He then combines this measure with a set of financial indicators to create a FCI and estimate its impact on growth.

The paper finds that an enhanced FCI, i.e. one that includes banks’ lending standards along with short-term interest rates, interest rates on corporate debt, equity returns and the dollar real effective exchange rate, has a meaningful impact on future growth. The impact of tighter lending standards in particular is important both because of its direct effects on credit and growth and (more so) because of its implications for other financial variables.

This latter point is critical: Swiston finds that tighter lending standards can magnify the adverse impact of lower credit supply on GDP growth due to their undesirable effects on stock markets and on the prices of corporate credit.

What should we make of this? I personally see a couple of implications, that keep me awake at night (along with Ben). The first is that commercial banks have been tightening their lending standards since October 2007, and continued to do so meaningfully during the last quarter of 2008. Unless we see a stabilization (or reversal!) on this front, a sustained improvement in the growth outlook (and bond and equity markets for that matter) will remain in the realm of Hope.

The second is a policy implication. The Fed’s TALF, to be launched this Thursday, is designed to support credit supply by deploying non-bank investors such as hedge funds into the credit and securitization markets. The idea is partly that, if commercial banks (which are the ones covered by the SLOOS) can’t function properly –hey, let’s just bypass them and ensure that credit continues to flow and GDP growth is not undermined.

My reading of the above paper tells me that this would be wishful thinking. Banks continue to play a critical role in financial intermediation and unless we try to fix them we will be bouncing up and down the market bottom for a (long) while before we can lift off again.

Evidently, this is not news to Geithner & co. But the delays in designing and implementing the TARP (which, by the way, was announced before the TALF) tells me they might need a reminder.

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!