A hopeful way out

Call the President!

The indispensable John Jansen has hit upon a way of preventing the next teetering shoe in the financial crisis from going thunk. So far, we’ve heard surprisingly little from the long maturity financial intermediaries — insurance companies (excluding the counterfeiters at AIG FP) and pension funds. Apropos, JJJ notes

Metropolitan Life announced that in its holdings of corporate bonds they are sitting unceremoniously on $14 billion in losses. I suspect that they are now hoping that advances in medical science will render current actuarial assumptions void and vacuous and the time value of money will work in their favor.

Really, Mr. Obama, has there ever been a better time to fund a Manhattan Project to invent immortality! Kill two birds with one stone. It’s immediate stimulus, quick-start investment in a sector where the USA retains a comparative advantage, high-tech medicine. Plus it’s a nearly bottomless, um, well of employment opportunity for less skilled workers, who could comb the Lake Okeechobee environs in search of the Fountain of Youth. If successful — and of course it would be successful, this is America, can do, yes we can, shut up we can too — it would save the financial system from the slow tremors of unfunded baby boom retirements and unpayable life insurance obligations. No, Mr. Dole, building a better Viagra doesn’t cut it. However, an appeal to the patriotism of Dr. Carlisle Cullen might yield rapid progress.

Our financial system is not the same as “our” big financial institutions

I’ve just listened to NPR’s recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation.

As an aside, we’ve come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn’t that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it “more responsible” to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?

Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner’s repeated conflation of our “financial system” and our “institutions”. Mr. Geither’s unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are “strong”. But that’s not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become “too big/complex/interlinked to fail”, but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.

We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of “Mussolini-style Corporatism“. Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it’s pretty clear that quite a few familiar financials have failed the market test. What’s good for Citibank is not what’s good for America.

Did you catch this bit from Warren Buffett’s letter?

Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

“Lemon socialism” has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don’t see how preventing healthy good banks from harvesting the organs of our megabanks “strengthens our financial system”.

I think it’s time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn’t mean that we would shutter all of Citi’s branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling’s #2) while the government backstops some obligations and seeks buyers for the bank’s assets, operating as well as financial. In other words, it’s time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that’s more likely in a world where Citi’s logo goes all retro chic like Pan Am. Frankly, I think that’s all the (non-negative) “franchise value” that’s left in Citi, and several of its peers.

How to fund financial system stablization

Word on the street today is that the Obama administration’s proposed budget includes a $250 “placeholder” for support of the financial system. (ht Economics of Contempt, Calculated Risk) President Obama made an admirable commitment “to restoring a sense of honesty and accountability to our budget”. However, his administration has failed to live up to that commitment with respect to financial system support. Unusually for government expenditures, the budgeted $250 billion dollars represents an estimated “net cost”. It presumes recovery of a substantial fraction of funds “invested” and actually enables cash payments that might amount to $750B. (See EoC, Marc Ambinder.). In plain English, buried in a $3.55 trillion dollar budget as a $250 billion dollar placeholder is a plan to more than double the controversial and unpopular TARP program, whose original enactment nearly tore the political system apart.

We do have a bit more transparency this time about how the “Capital Assistance Program” will be managed. Taxpayers will purchase securities at prices which, as Michael Shedlock points out, appear to have been back-dated in order to give taxpayers a raw deal. In an astonishing abuse of the customary language of finance, the “convertible preferred” shares the government intends to purchase, in addition to mandatory conversion after seven years, are convertible to common stock at the option of the the banks, rather than at the option of the taxpayers holding the securities. James Kwak unearthed this bit of chicanery in the must read piece of the day. In addition, existing bank shareholders would be protected upon any conversion by “customary anti-dilution adjustments”. God forbid that shareholders in bankrupt institutions who would otherwise be wiped out entirely get diluted. The poor dears. (To be fair, it is inaccurate to characterize all institutions that will receive “capital assistance” as bankrupt. The new Treasury Secretary will almost certainly continue the old Treasury Secretary’s strategy of “encouraging” healthy institutions to take government money, so that angry taxpayers cannot use acceptance of funds as evidence that a bank is in trouble. Under the new program, any publicly listed US bank can apply for a capital infusion of up to 2% of risk-weighted assets as a matter of course.)

President Obama’s obvious intellect, idealism, and diplomacy are a breath of fresh air for a nation whose economic and political institutions have suffered a near catastrophic collapse. But the President cannot put his imprimatur on continued financial obscurantism and expect to retain a reputation for honesty and transparent government. It is wonderful that the President intends to come clean and account for the wars in Iraq and Afghanistan on-budget. But Mr. President, past and proposed expenditures to support the financial system dwarf the total financial costs of both those wars combined. This is not a small thing. You can’t hide the terms of these transfers in fine-print befitting a credit-card agreement and expect to retain your reputation with the American people for forthrightness.

Here is my advice to the U.S. Congress: Put $750B in the budget, right up front, for financial system stabilization. But don’t contribute another dime to Secretary Geithner and Neal Kashkari‘s little slush fund. Allocate funds to the sole use of the FDIC, for resolution of troubled banks as foreseen by Congress under the FDICIA (text). See this excellent piece by former bank regulator William Black. The government has been flouting the terms of a binding legal regime designed precisely to resolve insolvent and near insolvent banks transparently, at least cost to the taxpayer, in a manner that minimizes both moral hazard and systemic risk. Former Secretary Paulson’s ad hoc let’s-pretend approach has been tried, and has failed. Why not try following our own laws?

We have a new administration in Washington that claims to be committed to the rule of law and good governance. Congress should help the President achieve these goals by funding an accountable FDIC rather than by putting more discretionary funds into the hands of a compromised Treasury secretary.


Update: The always excellent Nemo also noticed the odd reverse-optionality of CAP “convertible preferreds”. He finds the coincidence of widely publicized insider purchases during CAP’s price-determining 20-day window to be intriguing as well. Purchasing shares with the intention of increasing their effective price to taxpayers under a foreseen government relief program would certainly constitute a crime. What did Ken Lewis know, and when did he know it?

(It’s worth mentioning that the allegation of backdating and that of insider price manipulation are mutually inconsistent — if insiders knew that the window would be 20 days preceding Feb 9 in late January, that implies the price-determining date was appropriately set in the future. You can either suggest that the date was chosen retrospectively, or that it was chosen in advance and shares were bought and talked up, but you’ve got to pick one conspiracy and stick with it. I guess if you’re really cynical, you might suggest that Feb 9 was tentatively chosen in advance, but only finalized when it was clear in retrospect that prices were advantageous, relatively speaking…)

Update History:
  • 26-Feb-2009, 5:15 p.m. EST: Added update re Nemo’s posts.
  • 26-Feb-2009, 5:25 p.m. EST: Added bit about inconsistency between back-dating and price-manipulation stories, and hedged the main text a bit, saying that the window appears to have been backdated rather than stating that as though it were fact.
  • 26-Feb-2009, 6:05 p.m. EST: Removed an “as the” to split an overlong compound sentence about Geithner countinuing to encourage healthy institutions to accept money so the zombies blend in.

There’s no reason for non-recourse

We don’t know exactly what Timothy Geithner has in mind for the “Public-Private Investment Fund”. But we do have a few hints. First, we know that among its purposes is that it

allows private sector buyers to determine the price for current troubled and previously illiquid assets.

And we also know, that on the very day Mr. Geithner offered his outline of a financial stability plan, the Federal Reserve announced its intention to expand its Term Asset-Backed Securities Lending Facility, or “TALF” to up to a trillion dollars, coincidentally the round number that Geithner suggested the “PPIF” might expand to. Hmmm. What is the TALF again?

Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral… As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets… The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

Does your head spin, acronym upon acronym, non-recourse, warranties, and covenants? Well, unspin it. The New York Fed is telling us, in plain and simple legalese, that it is planning to make a very generous gift to investors that participate in this program (and indirectly to the banks that sell assets to them). A non-recourse loan bundles an ordinary loan with an option to “put” the collateral back to the lender instead of paying off the loan. Sometimes this is not much of a gift: When a pawnbroker lends you half of what your Fender Stratocaster is worth, and the fact that you can surrender the guitar rather than pay off the loan is cold comfort. But if someone fronts you substantially all of what an asset is worth, and the value of that asset is uncertain and volatile, then the put option bundled into the “loan” becomes extraordinarily valuable. If the asset appreciates, you take the profits and “ka-ching!”. If the asset falls in value, the lender takes the trash and eats the loss.

A near-the-money option is itself a valuable asset. Offering non-recourse loans to participants in the PPIF would directly contradict the program’s goal of “allow[ing] private sector buyers to determine the price for… troubled… assets.” Private sector buyers would not be pricing the assets themselves: they would be pricing a portfolio containing a troubled asset and a free, three-year put option, courtesy of the Fed. Depending on how much of the transaction the government is willing to finance, the value of the put option could represent a substantial fraction of the value of the asset being priced. This is a subsidy, that would be incorporated in the sales price of the asset and split by banks and private investors. It amounts to the government bribing investors to certify banks as more solvent than they are, by overvaluing bank assets in subsidized purchases.

John Hempton wrote a very brilliant essay on what it means for a bank to be solvent. If you haven’t read it, go do. Hempton’s definitions 2 and 3 of bank solvency — current accounting value (which implies mark-to-market valuation for many assets) and economic value as an ongoing enterprise — diverge because the cost of funding for investors in risky bank assets is unusually high. Under these condition, Hempton reasonably suggests, private fund managers will be unable bid assets up to their best estimates of “hold-to-maturity value”, less a “normal” risk premium, because investors are desperately unwilling to hold anything other than government guaranteed securities. Definition 3 is a very generous view of what it means for a bank to be solvent, because it implies that the actual market risk premium is wrong, that an estimate of hold-to-maturity asset values by a reasonable analyst, even accounting for risk, would put those values above current market bids. But in evaluating bank solvency we should be generous: Since an insolvent bank must be nationalized (reorganized, received, conserved, preprivatized, whatever), we should try to avoid declaring as insolvent banks that do have positive economic value, since that would amount to a capricious expropriation of private property.

But generosity in evaluation is distinct from a generous cash gifts from taxpayers to banks and investment funds. What is required to get a generous but still accurate evaluation of bank solvency is inexpensive funding, so that analysts willing to bet on what a “toxic asset” is worth can borrow the funds they need to back their spreadsheets with shekels without giving away all the upside to nervous lenders. What is not needed, what is in fact positively counterproductive, is to give investors a special bonus in the form of a free option if they buy the asset. This guarantees that assets will not be accurately priced (they will be overpriced), and reduces analyst incentives to value assets carefully and generate reliable market prices.

I actually think having the government offer cheap, full-recourse loans on a maturity-matched basis to investors willing to bear the risk of holding currently disfavored assets is a clever idea. (“Maturity-matched” means investors don’t have to worry about margin calls: as long as they get the long-term values right, they can ride out any tempests in mark-to-maket prices.) We do need a market in these assets, and if it is true that funds availability for people willing and able to bear the risk of ownership is preventing such a market from arising, then by all means, that’s a “market failure” the government can correct. But the key point is that a market price is the price at which private parties are willing to bear that risk. If funds are provided non-recourse, much or all of the risk of ownership is absorbed by the lender. Any prices that result from “private” purchases by investors funded at high-leverage on a non-recourse basis are not market prices at all. Such prices would be sham prices, smoke-and-mirror prices, sneaky off-balance sheet public subsidy prices.

We are all tired of the lies, Mr. Geithner. By all means, let nationalization be a last resort, and do all you can to offer liquidity to private parties willing to take both the upside and downside of speculating in questionable paper. But if you keep nationalizing the downside and privatizing the upside, it will not be very long at all before the public concludes that stress tests and market prices are just a sleight-of-hand for Davos man while he picks our pockets, again. Act fairly, and you may end up nationalizing the worst few of the larger banks. Keep up the games, and we will insist that you nationalize them all. It is getting hard to believe that there is a banker in the land who has not already robbed us. Eventually we will tire of drawing fine distinctions.


Afterthought: There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ’em a ticker symbol, and put ’em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

Thank goodness…

…for Yves Smith.

If you aren’t shrill, you aren’t paying attention. Weren’t we supposed to be done with shrill now?

Bank insolvency: tips & tricks

So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that’s a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.

  1. Never, ever feed the zombies!

    Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at “hold to maturity” values. Just say no! A healthy financial system cannot be run by zombies. “Rescuing” insolvent banks makes about as much sense as tying string to the arms of a loved one’s corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it’s sure to smell really bad, and it’s gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.

  2. Help private individuals save good banks.

    A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:

    The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed… to produce fair accounts for Gotham. Ten weeks should do it… The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank’s viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can’t or won’t fund the bank in full knowledge of its position then it is nationalised.

    The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank’s shares until the loan was fully paid.

    In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks’ viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is “illiquid but not insolvent”, since the government has offered liquidity on generous terms to help get the deal done.

    (For the record, I view this procedure as too generous. As far as I’m concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people’s heebeegeebies about the government owning what it pays for, I’d put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)

  3. Nationalize, reorganize, privatize spin-off to taxpayers.

    Insolvent banks become wards of the state. They are nationalized. The “N-word”, as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn’t change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about “nationalizing”, say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.

    Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too “systemically important” to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.

    Henry Blodget suggests we

    refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn’t appropriate for people to get paid.

    But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO “pop” goes to flippers, not to the firm or its original shareholders. There’s a deep literature on the phenomenon of “IPO underpricing”.)

    Here’s an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they’d quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value “toxic” assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.

    This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild “stimulus” — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it’s far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.


Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. “Compare and contrast” is a fruitful exercise. The spin-off idea owes something to this perspective.

London calling

So, I like to go on about how we don’t have a financial system, how the system we have is inadequate and structurally broken, how we need to invent new institutions. I think we need to experiment, in a startup-y, techy kind of way, with more flexible, fine-grained, and transparent exchanges that could augment and perhaps replace traditional capital markets. Really, that’s what I want to do someday.

Unfortunately, I’m slow and lazy. But occasional commenter Thomas Barker is not. He writes to say he’s helping to organize an informal meeting in London of people interested in pursuing just these kinds of projects. I desperately want to go, though I’m afraid the odds are slim. The event will take place on February 14th. (Yes, how romantic.) For more information, try here.

Winterspeak wonderland & miraculous Mencius

I’ve been flabbergasted by just how good Winterspeak has been lately. I don’t agree with all of his conclusions, but the perspective he’s developing is quite beautiful, and very useful. I’m going to highlight a few of the bits I really like, and add a bit of spin.

I want to start with a related insight from the excellent Mencius Moldbug. Apologies to Mencius if this isn’t the best reference, but the point is very clearly stated, in a comment at Brad Setser’s:

Money is the bubble that doesn’t need to pop. As long as there is demand for indirect exchange, at least one asset will be stockpiled by hoarders, hence experience demand that is not a consequence of any direct utility, hence be overvalued. As long as the storage cost for this asset is zero and the supply in existence is fixed, you have a perfect Nash equilibrium – using any other asset as a medium of indirect exchange provides no advantage, and runs the risk of buying into a bubble which will subsequently pop as punters revert back to the stable standard.

This idea stands in stark contrast to the view recently offered by John Cochrane:

The value of government debt, including money, is equal to the present value of the primary surpluses that the government will run in order to pay off the debt. Nominal debt is stock in the government, a claim to its taxing power.

I think Mencius’ view is more accurate. [1]

The next insight I will attribute jointly to Mencius and Winterspeak (while quoting neither): When a government implicitly or explicitly guarantees deposits and other bank debt, it is useful and in some ways more accurate to describe the arrangement as loans by individuals to the government and then separate loans by the government to banks. If bank loans sour, it is the government who is out the money. Bank creditors do not discipline banks, or select banks based on their investing acumen. The connection between the deposit base of a bank and that institution’s ability to lend is formal and vestigal, and is disappearing as reserve requirements become an ever less binding constraint on bank lending. (I’m pretty sure I’ve read both Winterspeak and Mencius make this point, but I can’t find great quotes. Here’s an example from Winterspeak.)

This idea foreshadows the new Winterspeakian synthesis that has me suddenly awestruck. Winterspeak presents a view of the monetary/finacial system in which the government is ultimately the hub. As above, when we “save” without explicitly investing, we don’t lend to banks which then lend to businesses. We lend to the state — we hold instruments that are ultimately claims against the state — while the government organizes the distribution of loans, implicitly via how it structures bank lending or explicitly by various forms of directed credit. But the government’s role is deeper than that. Here’s Winterspeak’s counterintuitive, but obvious-once-you-think-about-it view of taxation:

Everyone agrees, more or less, that the Federal Government has the power to print money. That’s what fiat money means by definition. Since the Federal Government can print it’s own money, in whatever quantity it chooses, have you ever wondered why it taxes at all? In fact, if you chose to mail in your 2009 taxes in crisp Federal Reserve Notes, the Government would take that paper money and shred it.

The Federal Government does not need taxes in order to spend. At the Federal level, because the Fed is a currency issuer, the sole purpose of taxes is to extinguish money, reduce aggregate supply, and therefore limit inflation to a tolerable level.

But if the government destroys money, it also creates it:

The Government creates money and transfers it to the private sector by spending. The private sector transfers the money amongst itself (spending, investment) and puts the rest in the bank. If the private sector wants to put more money in the bank, that money can either come at the expense of transactions, or it can come from the Government simply running a larger deficit, and thus creating additional money for the private sector. So long as the private sector uses this money to save, it’s creation is not inflationary and will not show up in the CPI. Inflation is caused by too many dollars chasing too few goods, and dollars under the mattress are not chasing anything.

There’s an elegance to this perspective that comes with what is of course oversimplification. Winterspeak invites us to consider the government, the central bank, and the private banking system as a consolidated entity. Money taxed, lent to the government or deposited in a bank is money destroyed (at least temporarily). Money spent by the government, or borrowed from a bank is money created. Questions of control are not addressed — we don’t know whether it is Congress, the Fed chair, or private bankers who most influence this public-private hybrid at the core of the monetary system. But thinking about money this way cuts through a lot of confusion.

Let’s combine all this with the Moldbugian insight that money is the bubble that needn’t break, that its value is due to the stability of a Nash equilibrium — as long as everyone wants it, it is rational for everyone to want it. The government/banking system, then, has the incredible power of creating what everyone wants or destroying it, as it sees fit via spending and taxation, but also via lending and borrowing. However, there may be constraints on its ability to use that power, for institutional and political reasons, but most profoundly because of the dynamics and potential fragility of Nash equilibria. We’ll come back to this.

Both John Cochrane and Paul Krugman would agree that the current crisis, at least in part, is a phenomenon related to an unusual increase in people’s desire to hold money. Moldbug’s Nash equilibrium is on overdrive somehow: all everyone wants is what everyone wants, claims against the government that the government can create or destroy at will. To understand the implications of this phenomenon, we have to add a bit more substance to the meaning of “savings” and “investment”. We’ll follow Winterspeak’s treatment first, which is remarkably insightful, although I don’t entirely agree. (I hope W— will for give me for lifting such a large chunk of his post, but I’d not do it justice in paraphrase.) Winterspeak:

The Issue

Essentially, Cochrane and Fama both assert that savings = investment (+ capital account), and so say that any Government stimulus will crowd out private investment. Here’s the derivation (by identity) to get you S = I

Y = C + I + G

National savings can be thought of as the amount of remaining money that is not consumed, or spent by government. In a simple model of a closed economy, anything that is not spent is assumed to be invested:

NationalSavings = Y – C – G = I

If you think that banks make (investment) loans based on their deposits, then it’s reasonable to assume that all money not spent (ie. saved) is invested. But banks do not take deposits and loan them out. In fact, banks make loans first and then those loans become deposits. Remember — loans create deposits, deposits do not “enable” loans.

Loans create deposits

Banks, by way of their Federal charter, can expand both sides of their balance sheet at will, subject to capital requirements. This money is created ex-nihilo, but always nets out to zero in the private sector, as each (private) asset that a bank creates must be matched by a (private) liability. Government can create money outside of the system, but banks always need to net out and balance the balance sheet.

People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.

Facts on the ground

If a description of how banks actually work doesn’t shatter your belief that savings = investment, consider Reality. From about 2000-2006, American savings went negative, yet banks loaned out huge amounts of money (made huge investments). In fact, they came up with all kinds of clever ways to skirt capital requirements so they could make even more investments. If savings = investments, and savings fall, how can investments rise? By the same token, from 2006 to now, the private sector has actually delevered, saved, but banks aren’t making any loans (investments). What’s up with that?

More Facts on the ground

Anyone who thought they were saving by putting money in the S&P500 has had a rude wakeup call. They were not saving, they were investing, and now 40% of that money is gone. I don’t think they will confuse saving with investing in the near future.

So, what is savings?

A better way to think of savings is to think of it as what’s left after taxes, consumption, and investment.

Y = C + I + G

Net Private Savings = Y – C – I – T = G – T

Austrians will howl that it is unreasonable to define savings as a residual, there should be a term S for active savings, but people have to save in currency, and in a fiat, floating fx, non-convertible world, currency is not a store of value. Fiat currency trades bankruptcy risk for inflation risk, and fiat currency is all that’s sitting in bank accounts. So the Austrians are right, there should be some way to actively save, but they are wrong, because fiat currency in a bank is not it.

You split out savings from investment and you get Net Private Savings = Government spending – Taxes, also known as the deficit. So, the Government runs a deficit (spends more than it taxes) in order for the private sector to have the extra money it needs, after consumption, investment, and paying those taxes, to net save. This idea totally blew my mind when I first encountered it, but it actually makes total sense.

So, if you acknowledge that savings does not equal investment, then you see that Government deficit enables private savings. This is the OPPOSITE of all the Chicago guys who argue that the Government deficit REDUCES national savings. Government is a currency issuer, why does it need to save? Does a bowling alley need to hoard the points it awards for strikes and spares? Everyone acknowledges that the Fed can print money, but few people actually think about what that means.

There is so much meat in this. First, a quibble. Winterspeak is disingenuous when he suggests that the disconnect between the miniscule savings rate and the maxicule investment rate argues against the traditional closed-economy identity S = I. The US very much was not a closed economy. The US was importing capital at a breathtaking rate to fund its investment boom, and globally the traditional S = I identity always held. In Bernanke-speak, a Chinese and Middle Eastern savings glut funded an American investment boom. That Americans saved less than they invested hardly mattered, as long as foreigners were willing to lend.

Winterspeak has not really disproved anything here. He has just derived a different definition of savings. The reason this is important is because we talk about savings, economists and real Americans alike slip between the two definitions unconsciously, which badly muddles things. On the one hand, we talk about the savings rate, which most certainly includes investment: If you were contributing to your 401-K or buying farm machinery, you were doing your part to keep the US savings rate above zero. But on the other hand, when we say that during this crisis, Americans’ shift to savings is proving disruptive of aggregate demand, what we are talking about sudden desire to hold claims on money rather than to invest in real capital. Let’s disentagle these two phenomena. Keeping with a closed economy, we’ll define:

Investment = Y – G – C (Traditional savings)
ΔClaimsOnGovt = Y – C – I – T = G – T (Gov’t deficit = Winterspeakian savings)

Actually, this is my party, and I hate how private expenditures are conventionally disaggregated into investment and consumption, while government expenditures are just “G”. So, let PC be private consumption, PI be private investment, GC be government consumption, and GI be government investment. Then:

Investment = Y – GC – PC = GI + PI (Traditional savings)
ΔClaimsOnGovt = Y – PC – PI – T = GC + GI – T (Gov’t deficit = Winterspeakian savings)

So here’s a bit of insight: We can increase Winterspeakian savings in three ways: by increasing government consumption, increasing government investment, or reducing taxes. But note that an increase in Winterspeakian savings only results in traditional savings (current new investment) if the government purchases investment goods. I don’t wish to take a side on the stimulus debate now, but I do want to point out that when people use the normatively charged word “savings” to imply investment, a tax reduction that enables purchases of bonds doesn’t cut it. A tax reduction increases claims against the government without increasing aggregate investment. Individuals imagine they have saved, but collectively, we have only reorganized claims surrounding the consumption and investing we were already doing. (Arguably a tax reduction could saturate the demand for government claims and lead to more real private investment. But that’s a dynamic scoring kind of story.)

Fundamentally, Winterspeakian savings is about restructuring our collective balance sheet in a way that leaves individuals with more claims on government. If the private sector reduces investment and the government increases investment to take up the slack, the ultimate result is the government controlling more real capital, and individuals holding claims on the government. In other words, what the private sector is doing right now is using financial markets to demand more socialism. Individuals no longer want to hold direct claims on private enterprise. They wish to hold claims on government, which implies the government must own and direct the productive activity that will enable it to make good on all those claims.

Regular readers may have noticed that I love telling ironic capitalists-are-socialists kind of stories. But I don’t think a shift towards public ownership of the means of production is a good thing. A consumption-centered stimulus or tax cut would keep the government out of the business of investing while enabling people to hold more money, but that would lead to reduced future production despite an increase in “risk free” claims against government. Today’s “savings” would be a losing investment, in real terms. That is, if we satisy the public’s demand for an increase in government claims, but do not invest the proceeds well, we should expect a great inflation. Hopefully, we are capable of identifying sufficiently productive infrastructure and public goods investments that the government can earn a real return without interfering in the traditional private sphere. But in the intermediate term, there will be no substitute for increasing PI. We need to persuade individuals to undertake investments whose risk they hold and bear if we want to have a capitalist economy. We need a private financial system.

But did we ever have one? If you buy the Moldbug/Winterspeakian view of banking, we did not to the extent that individuals used the banking system to intermediate investment. Instead, the government effectively created incentives for bankers to invest in good projects by letting them keep the proceeds when they chose well, while punishing them a bit but then eating their losses if they chose poorly. We could reproduce that system more directly by having the government invest in private equity funds. Is that what we want?

We really need to think clearly about what we used to have, what was good and what was broken about it, and what we want going forward. How much should investment risk be socialized, to encourage entrepreneurship, vs how much should be borne privately, to encourage discrimination? Would it be possible to build the right mix transparently, rather than to rely on hidden guarantees and subsidies as we have until now? (It may be that subterfuge is prerequisite to an effective financial system in a political world. But I don’t like to believe that.) To the degree that the investors will actually bear investment risk, can we define instruments that they can productively invest in? As index investors have learned, bearing risk without discriminating between good and bad is a prescription for disaster, eventually.

This has gotten terribly long, and terribly rambling, but I do want to come back to one idea. Early on, I described a Winterspeak/Moldbug synthesis in which the government comes off as incredibly powerful. Government money is what everybody wants because everybody wants it. The government destroys money through taxation and borrowing, and creates it by spending and lending, and can do so at will. A very large fraction of “private” lending is in the influence of government, by how it organizes the pseudoprivate banking system as well as via direct market interventions. With so much power, what are the government’s constraints? Why can’t it get an outcome that it wants, presumably a good economy with a bit of corruption on the side? Let’s put aside the institutional stuff. (For example, governments usually have to pretend private banks are private; their ability to direct the loans they guarantee is limited; in fact, a bankers-control-government-expenditure story is historically more compelling than government-controls-bank-expenditure). Right now, the government can pretty much do what it wants with the banking system, can expand the quantity of risk-free claims to meet demand at will, can lend to whomever it pleases. Why can’t it fix the country?

Cassandra had a brilliant post not long ago called “an idea crunch“. Read it if you haven’t. Ultimately, a financial system has to find productive projects for the private parties to invest in. The government can invest directly, can delegate investment to the best and the brightest, can saturate the public’s demand for money until private parties try to find other means of storing wealth. But it’s what real human beings do with real resources that ultimately matters. Our financial system didn’t fail because it was overlevered. It failed because it was uncreative: It could not conjure up worthwhile things to do with the capital it was asked to invest, and instead of owning up to that, it pretended that poor projects were good. Financial markets are ultimately information systems. The only way out of this is to discover worthwhile things to do, or more importantly, to develop better means of generating a diverse menu of worthwhile things to do going forward. Right now, the government is being asked to do what the semi-private financial system could not: generate a positive real return on trillions of dollars of undifferentiated future claims. The stakes are very high — that Moldbugian monetary Nash equilibrium can be a bitch. Money is the bubble that need not pop, but that’s no guarantee that it won’t. Anything that’s desirable only because everybody desires it is just a single major failure away from being yesterday’s darling. If unthinkable banking system failures can occur, so can unthinkable failures of the monetary system.


[1] I think Cochrane’s essay has been too roughly treated in the blogosphere, and I don’t wish to pile on. A fair reading of the piece makes it clear that Cochrane is not making the elementary errors that an excerpt from the beginning might suggest. I quote Cochrane’s essay here with some affection. I think his view of money is wrong, but like nearly all of economics it is better read as a form of organized hope that the world might be rendered coherent than as a reliable description of the world as it is.

Did the Swedes nationalize? What does that mean, anyway?

In an earlier post, I took Kevin Drum to task for referring to partially state-owned, but publicly listed Nordbanken, as “the state bank”. I noted then that I didn’t know what percentage of the bank was state-owned.

Kevin Drum is not lazy. He’s managed to dig that up. In an e-mail, he reports that at the time of Nordbanken’s nationalization, it was 77% state-owned, and private shareholders were bought out at better than the market price. At 77% government ownership Kevin’s characterization of Nordbanken as a state bank seems pretty defensible. (That the Swedes bought out the old shareholders doesn’t interest me very much, as long as the bank’s price had already collapsed. For example, paying Citi’s shareholders a substantially above-market $4 per share — Citi closed at $3.11 today — after the shares have fallen in value by more than 90% wouldn’t much change the incentives of pre-crisis shareholders.)

“Nationalizing” a bank already 77% owned by the state might not seem like a big deal. But, reading an insider’s account of the Swedish crisis, it was a big deal:

The crisis continued. We had to make a big quick fix for Nordbanken. However, it was soon clear that the quick fix was not enough. So we decided to nationalize the bank and recapitalize it. Nordbanken was very large, as its asset base equaled 23 percent of GDP. The initial cost of recapitalizing Nordbanken equaled 3 percent of GDP. A few years later we were able turn it around at a profit for the taxpayers and that transaction, more or less, paid for the banking crisis.

The restructuring of Nordbanken was really important in that it served as a showcase for the rest of our work. It demonstrated the government’s determination to address and resolve the crisis and it helped us to gain respect.

Britain is in a similar situation today. The British government already owns 68% of RBS, but the question of whether or not to “fully” nationalize the firm remains important. Why? What’s the difference between a “full nationalization” and majority ownership? Does “full nationalization” matter?

I think it does matter, quite a bit. First, there is the obvious matter of unity of control. A fully nationalized bank can be reorganized in the public interest, e.g. by division into smaller firms, without minority shareholders complaining or even suing on the theory that a different structure would be more profitable.

More importantly, only full nationalization eliminates investors’ incentives to concentrate capital in “too big to fail” banks before the crisis. Assume that a bank is insolvent, such that if it were not “too big to fail”, regulators would insist it merge or wind down at a cost the the deposit insurance fund. But the bank in question is too big to fail, so regulators cannot wind it down. The government is then forced to become the capital provider of last resort. Existing shares would be worthless under this scenario, if the bank had no power to threaten a chaotic failure. However, after a recapitalization, the reorganized bank might become a very valuable. The bank retains its existing network of branches, benefits from the deposits and habits of its old customers, and may leap from sickest bank to safest bank with a single “bold” injection of government capital. If the old shareholders are permitted to ride along after the reorganization, they reap a large reward from having invested in a bank that was too important to fail.

Suppose that a bank whose true book equity is $0 has failed to mark down some assets, and shows a position of $10B. The bank receives a $90B capital injection, valuing existing shares at book. Then the old equity whose true value was precisely zero prior to the recapitalization suddenly has a real book value of $9B. That is, old shareholders reap an immediate windfall from the recapitalization, and the size of the windfall increases in direct proportion with the amount to which management had lied about the banks losses! Further, the market value of old equity should rise by much more than that $9B, since all of a sudden, the bank switches from a horseman of the apocalypse to a going concern with a bright future. Failing to exclude old shareholders from a post-recapitalization bank results in a transfer of wealth from taxpayers to shareholders in proportion to the degree to which i) they invest in “too big to fail” banks, and ii) encourage management to understate asset impairments in their books. Those are really bad incentives. The details of this story change a bit if, for example, the recapaitalization comes in the form of preferred equity with warrants, or if market values rather than book values are used to estimate the how much dilution old shareholders suffer. But the core bad incentives do not change.

By eliminating private shareholders entirely, full nationalization permits regulators to “do what needs to be done” to restructure the firm without having to hew to a fiduciary duty of profit maximization in designing the new structure. Full nationalization limits the ability of shareholders to extract windfalls from taxpayers by becoming “too big or interconnected to fail”. Finally, full nationalization makes it possible to value assets ruthlessly, thereby eliminating market uncertainty about whether a bank is really fixed. Either to maximize their share of a recapitalized firm or to maximize the subsidy in a “toxic asset” purchase, legacy shareholders will always insist on optimistic asset values. But getting past a banking crisis requires working from an assumption of extremely pessimistic values.

So I do think that Nordbanken still “counts” importantly as a nationalization (and that AIG, for example, remains importantly undernationalized). But kudos to Kevin Drum for unearthing the public/private split. What do you think? Does a shift from 77% government-owned to 100% government-owned really matter?

Nationalize like real capitalists

It will come to no surprise of readers of this blog that I favor nationalization of failed, systemically important banks. But James Surowiecki and Floyd Norris have a point. We absolutely should not nationalize as a means of persuading banks to issue credit more freely. If the government (idiotically) wants looser lending than banks are willing to provide, it oughtn’t take their money and lend it. The government can lend its own damned money (well, our own damned money) if it thinks that profitable loans are not being made, or that for the good of the economy unprofitable loans must be made.

The reason to nationalize a bank is because the bank has failed and its former owners have no legitimate claim to its assets. The government has been forced to offer support with public money, thereby purchasing the corpse fair and square. We take the bank into public ownership because taxpayers who have been conscripted to accept extraordinary losses are entitled to whatever gains follow the reorganization they finance.

When a bank is nationalized, shareholder equity should be written to zero, and existing management should be handled as roughly as the law allows. If we have a bit of courage, we should impose haircuts or debt-to-equity conversions on unsecured creditors, but I don’t think we have that kind of courage. “Toxic” assets should be revalued at pennies-on-the-dollar market bids or else written to zero and hived into “bad banks”. Once we have a conservative valuation of the assets and know exactly what is owed, we’ll know how much public money would be required to cobble a robustly funded bank from the wreckage. However, if we recapitalize “too big to fail” banks without restructuring them, we will quite deserve our next mugging. We had better cut these monsters into little, itty, bitty pieces. We should embed strict size and leverage limits into their itty, bitty charters, restrict their ability to recombine, and then hire management to run the little things on strictly commercial terms. Hopefully we will change what it means for a bank to run on commercial terms — We should create a tax and regulatory structure that penalizes scale and leverage across the board. Better yet we should decouple the payment system from risk investment by reorganizing banking functions into “narrow banks” and credibly not-guaranteed investment vehicles. But whatever the banking industry comes to look like, nationalized banks should be recapitalized once, then managed to compete in it, and for no other purpose. Taxpayers should seek to extract maximum value from their eventual privatization. But should any of the reorganized banks seek a second helping of at the public trough, they should be ostentatiously permitted to fail. Rather than an implicit government guarantee, successors of nationalized banks should face a particularly itchy trigger finger.

Having nationalized “banks” make loans that prudent managers of a well-capitalized bank would not make is just a way of obscuring a subsidy and ensuring permanent quasipublic status by requiring on-going guarantees, bail-outs, and capital injections. Further, putting easy-lending public banks in competition with ordinary thrifts would resuscitate the destructive dynamic we have just put behind us, wherein bank managers must match the idiocy of their most foolish counterparts or watch their businesses wither.

If we want to stimulate the economy, put idle resources to work, stoke animal spirits, whatever, we should do that with some combination of transfers, investment subsidies, inflation, and public works. But if we are dumb enough to force-feed credit into the economy, let’s not hide that behind a bunch of puppet banks. And let’s keep it very clear that we are not confiscating private firms in order to make them tools of the state. We nationalize reluctantly, when we have had no choice but to inject public money (or guarantee assets, which amounts to the same thing) in banks that otherwise would have failed. We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers.


Some nationalization links

Update History:
  • 20-Jan-2009, 7:00 p.m. EST: Eliminated an artless overuse of “guaranteeing” by changing to “ensuring”.