America at the crossroads. Again

Put simply, if a financial system is to be deregulated (that is, allowed as much as possible to be self organising), participants must not be unduly protected from their own errors. If, on the other hand, the political decision is made that protection is to be provided, such that all these natural feedback mechanisms no longer work, then fairly stringent regulations must be enforced. What we ended up with was something like the worst of both worlds. For all their championing of free markets and responsibility, both this administration and much of the financial world resolutely sought (and still seek) to capture the rewards while laying off the risks to the taxpayer. “Privatise the profits and socialise the losses”, in other words.

Economic dangers such we now face can only arise when gearing becomes sufficiently widespread and extreme to distort whole asset classes and induce widespread malinvestment. Along the way, assets also become concentrated in weaker and more highly indebted hands. Since such collective lunacy can only unfold once the searing experiences of some earlier generation have been forgotten, they’re very rare. Our attempt, regrettably, has been without historical parallel. Not only in its extent but also in the proliferation and complexity of financial instruments, all designed to facilitate the trading, manipulation and masking of risk.

Much of this byzantine, headache inducing financial superstructure does cancel out and some was no doubt even used for the sensible management of otherwise unavoidable risks. Still, when the netting out is done, every remaining security is a net systemic exposure to risk. Any given participant can trade or hedge it away but the market as a whole can’t. What derivatives and financial engineering did - together with many other things of course - was facilitate the creation of a veritable Zambezi of such securities. The slicing and dicing, the ability to offload loans, the resulting separation of origination from responsibility, all these acted to supercharge an already overheated financial system.

In the US, the epicentre of this malignant growth was housing. Unlike us, they not only took prices to unheard of heights but also managed to grossly overbuild. At the peak of their boom in 2006, “real” prices in the US were about 50 per cent above their previous highest level, as was the price to rent ratio when compared to the top of the real estate boom in the late 80s. It was all fuelled by a torrent of financing initiatives, some of which (such as Ninja loans, standing for no income, no job, no assets) were truly surreal. Mortgage equity withdrawal topped 6 per cent of GDP and helped pushed consumption to over 70 per cent of GDP while the current account soared to over $800 billion.

This was madness writ large and there were many observers who understood what was happening (and the likely consequences) quite clearly. Even now, after falling some 15-20 per cent, housing prices remain far above historical norms and with the US either in or on the verge of recession, the outlook is grim. Not only for the real estate market but for the whole financial edifice to which it’s inextricably bound.

Such, then, is the nature of the central problem underlying the crises of the past year (central, because there are of course many others). Hardly surprising that it’s been stubbornly resistant to lasting solutions, that the enthusiasm attending each fresh effort from the authorities has soon slipped into an even deeper gloom.

Quite simply, the asset side of the financial system’s balance sheet has been shrinking much more rapidly than their liabilities, and fresh equity has become ever more elusive. Combined with a pervasive uncertainty about the true state of their own affairs (much less that of fellow institutions), this has dried up interbank lending and greatly reduced credit availability. A recipe, in short, for debt deflation and a severe recession, if not depression.

It’s no mystery, therefore, why Bernanke and Paulson desperately wish to find a way to short circuit this potentially fatal spiral. The question is whether the Troubled Asset Relief Programme (or TARP, in yet another of the proliferating acronyms of the last year) will do so, and even if it might, whether there are better ways to proceed.

All of the Fed’s efforts to date have been directed at providing liquidity. If, however, as in this case, insolvency is the real issue, such assistance can only be a short term palliative at best. The system’s slide towards the edge can only be stopped if it receives substantial new equity or the value of its assets is increased. As it stands, this plan only addresses the latter, and then only to the extent the prices it pays for these “troubled assets” are above where the market has them now.

This is neither just nor effective. Quite apart from the monumental potential for conflicts of interest and the opaque, highly authoritarian nature of the plan itself, taxpayers end up with all the risk and none of the potential reward while the institutions (and their managers) who were on the bridge when the system was driven onto the reef are bailed out and empowered to continue at the controls.

Thankfully, dissenting voices are proliferating and some of the alternative proposals address the problem far more equitably and directly. The most interesting ones all take as their starting point the desperate need to substitute equity for debt. Take William Buiter, for example:

Paulson’s proposal creates what Anne Sibert and I have called a "market maker of last resort" for some of the toxic assets of the banking system. But is does not, in and of itself, solve the problem of an overleveraged/undercapitalised US financial system. To get new capital into the banks, and to reduce leverage dramatically at the same time, I propose a mandatory debt-for-equity swap for all US financial institutions. For the most junior debt (subordinated or tier one debt), 100 per cent could be swapped for equity. For more senior debt, the share of the notional or face value of the debt that is subject to compulsory conversion into equity (preferred or common stock) would be lower. Even the most senior debt should, however, be subject to a non-trivial "conversion ratio" - 25 percent, say. This form of debt forgiveness would not extinguish the claims of the current creditors, but would convert them into equity - a pro-rated claim on the profits - if any - of the banks. It would have the further benefit of diluting the existing shareholders - a desirable action both from the perspective of fairness (I was going to say equity!) and from an efficiency point of view: incentives for a repeat of past incompetence, reckless lending and mindless investment would be mightily diminished. The proposal amounts to a compulsory re-assignment of property rights - a form of expropriation. So be it. Extreme circumstances require extreme measures. It is time for the creditors of the banks to make a more significant contribution to the resolution of the financial crisis and to the prevention of an economic crisis.