America at the crossroads. Again

The atmosphere in Washington is all too redolent of 2001. Swept up in the turbulent aftermath of 9-11, legislators were easily stampeded into passing the Patriot Act. Few, as it turned out, had even read the Act, much less thought carefully about its implications.

Today, it’s the Professor and the Banker (as Bernanke and Paulson were dubbed over the weekend) who’ve pressed the panic button. According to Senator Dodd, they told congressional leaders on Thursday evening “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally”. It's tough for anyone, much less politicians up for re-election in November, to stand firm against such pressure. Nor, in fairness, can anyone reasonably claim the whole crisis is overblown; it’s only too real and has for quite some time had all the relentlessness of a slow motion train wreck.

What is truly remarkable is the proposed solution and the apparent haste with which it’s been cobbled together. It’s not, after all, as if they’ve been blindsided by the escalating crisis. Consider Paulson’s comment on Friday:

“Going back a long time, maybe a year ago, Ben, as a world-class economist, said to me, ‘When you look at the housing bubble and the correction, if the price decline was significant enough,’ the only solution might be a large-scale government intervention,” Mr Paulson said. “He talked about what had happened when there had been other situations historically.”

Indeed the study of past financial crises (in particular, the Great Depression) and potential official responses to them has been Bernanke’s enduring academic passion. He has, in fact, been prepping for this moment his whole adult life.

Under his leadership, the Fed has certainly been creative. As the crisis intensified, he unveiled a wide range of new facilities to bolster liquidity and prevent a systemic meltdown. The amounts involved have been large (in the many hundreds of billions) but until now, the basis of all these actions was to provide credit against pledged assets, albeit ones of steadily declining quality. For all the noise and fury, before last week the monetary base had grown a mere 3 per cent over the last 12 months. (Mind you, without the seemingly unending foreign purchases of US dollar assets the Fed could not have adopted such a comparatively low key stance.)

Now, though, all is about to change. One can only assume the failure of the markets to heave a sigh of relief after the sudden $85 billion bailout (and effective takeover) of AIG must have crystallised Bernanke’s worst fears. The intemperate language, the sense of urgency and the radical nature of the proposal they took to Congress suggests Bernanke & Co could see the whole financial system being sucked into a black hole. Unfortunately, given the degree of leverage, the opacity of many of its assets and the pervasive and growing sense of uncertainty, this is not an entirely unreasonable fear.

What, then, of the proposal itself, granted that political horsetrading may change it substantially in the days to come? Or maybe even sink it entirely, although given how the debate has been framed this really would be a shock. The full initial proposal can be found here. A few snippets will give a sense of how much it packs into its crisp 870 words:

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase. The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States. [Overseas institutions: This is apparently going to be expanded to allow purchases from overseas institutions.]

Sec. 6. Maximum Amount of Authorized Purchases.

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

It isn’t difficult to see why eyebrows have been raised, not all of them unfriendly. Indeed, some have wondered aloud about its constitutionality. If passed, it would be a remarkable expansion of executive power, even by the standards of this administration. Still, our intent here is to consider only its likely economic effectiveness.

In order to make any sense of the proposal, or the events which prompted it, we must look a little more closely how things came to such a pretty pass.

A market based economy is a complex, self organising system. In order to adapt and prosper, such systems must have constant real world feedback. In the case of the financial system in the US (and, to varying degrees, elsewhere), that loop has for decades been clogged and distorted. Implicit or explicit central bank guarantees together with various government support schemes over time fundamentally altered the perception of risk. Combined with central bank accommodation, this encouraged credit growth to far exceed all historical parameters.

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.

Or Professor Luigi Zingales of the University of Chicago:

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

The decisions that will be made this weekend matter not just to the prospects of the US economy in the year to come; they will shape the type of capitalism we will live in for the next 50 years. Do we want to live in a system where profits are private, but losses are socialised? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behaviour is penalised and prudent behaviour rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

Nicholas [Gruen] already drew attention to Steve Waldman of Interfluidity who takes a similar, if slightly more radical, approach.

All these proposals allocate losses (and potential profits whenever this crisis is finally over) in a far more equitable manner. They also have the great virtue of enabling the market, as much as is possible in such dire circumstances, to determine the ongoing pricing of assets. Last, and by no means least, they would lay the foundation for a more sensibly structured financial system.

Paul Krugman, as he often does, summed things up nicely:

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded - if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

Recent history isn’t all that encouraging but one can only hope these saner voices make themselves heard above the panic in time to avert an even greater catastrophe.